The EU-UK Future Trade Relationship after Brexit: Is There a Middle Ground?

Anton Muscatelli | 26 January 2018

© 2017 European Union

As the UK and EU are about to embark on phase 2 of the Brexit negotiations, the key question is what form the future relationship will take.[1]

The opening salvos between the EU27 and the UK have already been fired. The European Commission lead negotiator Michel Barnier has set out the EU27 position very clearly, in a chart which makes it clear that the UK’s Brexit red lines on no ECJ jurisdiction/regulatory autonomy, no free movement of people, no financial contribution to the EU budget, and the UK’s desire to develop an independent trade policy are driving it inexorably out of both the customs union (CU) and the European single market (ESM):

The EU’s position is simple: if the UK red lines stay in place the only solution for the future UK-EU relationship is to negotiate a free-trade agreement (FTA) along the lines of the recent FTAs negotiated by the EU with Canada or South Korea.[2] In economic terms, this will be a ‘hard Brexit’ and will be extremely damaging. Most independent economic analysis agrees with this assessment (see e.g. Ebell et al. 2016, NIESR and OECD).[3]

It is also a position shared by many political voices. Most recently, the Scottish Government published Scotland’s Place in Europe: People, Jobs and Investment (SPIE2). It shows (see table below) that for Scotland a Canada FTA-type deal will involve GDP being -6.1% lower by 2030 than would be the case if EU membership was retained. A no-deal Brexit would be even worse, with a -8.5% loss in GDP relative to the baseline. In contrast, a ‘soft Brexit’, retaining EEA membership and hence full participation in the ESM. would trim the GDP losses by 2030 to -2.7%:

Headline Macroeconomic Indicators by 2030 Relative to a Baseline of Full EU Membership

 GDP (%)GDP Per Capita (£)
in 2016 Cash Prices
Real Disposable
Income (%)
Business
Investment (%)
EEA-2.70%-£688-1.40%-2.90%
FTA-6.10%-£1,610-7.40%-7.70%
WTO-8.50%-£2,263-9.60%-10.20%

Source: SPIE2; Scottish Government Global Econometric Model (SGGEM)

The Standing Council on Europe for the Scottish Government, which I chair, has endorsed this analysis and the rest of the evidence in the SPIE2 report. In addition to the above costs of exiting the single market as it currently operates, there are the opportunity costs in the form of unrealised gains (not included in the above table) of a further 2.4% of GDP as the EU completes the single market in network services, professional services and retail.

Indeed, services are the Achilles heel of any FTA, even a comprehensive deal such as the Canadian one.[4] Whilst it is not impossible to foresee a Canada-style FTA with tariff-free UK-EU trade in goods, there are two problems. First, the UK economy and its exports are dominated by services, particularly financial and professional services. Services make up 70% of the UK economy and 40% of exports and would not be included in a Canada-style FTA. Second, the integration of UK value chains with the EU in manufacturing, with the UK prevalently operating upstream in those value chains, will be seriously damaged by the UK being outside the ESM and the CU. Most likely, manufacturing companies will begin to move operations to the EU so that they can operate seamlessly within the ESM and CU.

A free trade agreement better than Canada?

The UK’s position is one which seeks a better deal than a Canada-style FTA. In essence, the argument is that the UK starts from a position within the ESM and with complete regulatory alignment with the EU27. Why should the EU and UK settle for a sub-optimal deal such as a Canada-style FTA? Why not develop a bespoke relationship with ‘frictionless’ trade in goods and services?

As the Barnier ‘staircase’ chart makes clear, that would be difficult without a commitment to continued UK regulatory alignment with the EU27. That regulatory alignment has to be supplemented by a surveillance authority and indirect monitoring through the ECJ, or an EFTA-type court in the case of the EEA solution. In that scenario, financial contributions would also be sought. The same would be the case in a Swiss-style model.

The Swiss model is the only one that relies on bilateral treaties and not on the jurisdiction of the ECJ or an EFTA-type court. But one problem with the Swiss model is that it’s not as good as ESM membership. In financial services, Swiss companies do not have unfettered access to the ESM (‘passporting rights’). In addition, the EU is clear that it does not like the static Swiss model, as unlike the EEA model it cannot easily adapt to new EU legislation and can lead to potential disputes, as the bilateral treaties have to be renegotiated to adapt. And the requirement of free movement, which has proved such a difficulty for Switzerland in terms of internal political divisions, would breach one of the UK red lines.

So are the EU and UK red lines mutually exclusive? Is there no effective negotiating space which would allow the UK to do better than a Canada-type FTA?

It would seem so, as this would involve what the EU has disparagingly called ‘cherry-picking’ by the UK. But let me engage in a willing suspension of disbelief. To use a science-fiction metaphor, if the EU were to allow some exploration of the interdimensional spaces in the Barnier ‘staircase’ chart, the negotiation might move in one of the following directions during phase 2. I’ll sketch out three possible scenarios.

Soft Brexit over the long term

First, an EEA/soft Brexit in all but name. Because of the UK ‘red lines’, to avoid an internal political crisis, the UK government would need to use the transition/implementation period after the UK leaves the EU in March 2019 as a route to a soft Brexit. The transition/implementation period will probably involve the UK adhering to all the rules of membership (budget payments at current levels, free movement, full ECJ jurisdiction). Indeed the UK would behave in all respects as if it was a EU member, except that it would not participate in the EU institutions.

A minimalist heads of terms might be negotiated by late 2018 which talks about the desire to negotiate a ‘deep relationship’ in the coming years, and the implementation/transition would last beyond the next UK general election, allowing for a political majority to emerge around an EEA-type Brexit. Post-2022 the two sides might then agree that an EEA solution is the only logical endpoint. Depending on the politics post-2022, it might even involve some safeguards on freedom of movement, with the UK implementing the freedom of movement rules to the letter, and a UK-only version of the EFTA Court and EFTA Surveillance Authority (EFTA2).

At present, this scenario is blocked by the UK government’s insistence that the implementation period will be no longer than two years (i.e. will end before the next UK general election scheduled for 2022), and by Michel Barnier’s recent statement that he would like to ensure that any post-Brexit transition will end by 31 December 2020, to ensure that the EU can enter its next financial cycle without the shadow of Brexit.

Partial integration into the single market

Second, partial integration of the UK into the ESM. If one focuses on existing models as blueprints, the main models for partial integration are the Swiss and Ukrainian/Eastern neighbourhood model. These deals were done at particular historical points in the EU’s relationship with these countries and they were, at the time, bespoke solutions. As noted, the EU does not want to do another deal on Swiss lines, and in any case the UK’s major concern is to gain access to the ESM for its services exports, especially financial and professional services.

The Ukrainian model allows for access to the EU market for services but in essence the EU is a rule-maker and the Ukraine has to accept complete alignment. The UK would have to accept complete alignment as well as ECJ jurisdiction over this key sector, with even less influence than EEA/EFTA countries over shaping regulation in these sectors. Given the importance of the financial services sector to the UK, it is possible that the EU might also require financial contributions in exchange for access.

Some commentators have suggested that ‘reverse Ukraine’ might be a possible model. This would involve the UK maintaining complete regulatory alignment in sectors where UK-EU trade is important, and would conceivably allow some regulatory divergence in other sectors. The problem with this solution is that it’s not easy to segment ‘industries’ or ‘sectors’ in this way.

As the UK develops new legislation or market regulation (e.g. on environmental regulation or product specifications) it would cut across many sectors making the whole agreement ungovernable. Who would adjudicate on any disputes? Having the ECJ as sole arbiter would again be a complete capitulation for the UK, and worse than an EFTA/EEA model in that sense. The Ukraine model only makes sense because the Eastern neighbourhood countries would like to converge over time with the EU acquis. The model does not work well if the UK would like to (even selectively) diverge.

A ‘regulatory partnership’ between the EU and UK

Third, there is a model which some commentators, echoing some elements of the prime minister’s Florence speech, have labelled a bespoke ‘EU-UK regulatory partnership’. This would involve the UK maintaining complete EEA-type regulatory alignment in a ‘core tier’ of areas. Enforcement and surveillance would follow the EEA/EFTA model in these areas, or even the ECJ model if the UK was prepared to abandon control.

There would then be a ‘mid tier’ of areas which would involve joint EU-UK expert committees to look at regulatory parity and potential issues which might arise from regulatory divergence. There would be a third tier of areas (an ‘outer tier’) which would only involve regulatory co-operation between the EU and UK.

The weakness of this model is that it is very difficult to define a clear mapping of ‘areas’ onto sectors, and very quickly this model could undermine the integrity of the ESM through regulatory divergence in the second and third tier areas, which could impact onto goods and services sectors where trade volumes are significant. It is also a model where the EU loses complete control over the governance of its single market. It is not obvious why the EU would wish to run this risk unless the ECJ was the ultimate arbiter of whether divergence was excessive in the mid and outer tiers. And in this case, why would the UK prefer this model over an EEA/EFTA model, which would at least avoid direct ECJ jurisdiction?

In summary, the negotiation space between the existing models of trade agreement with the EU is a very difficult terrain to explore. Typically the EU has negotiated the existing models which deviate from the EEA model (Switzerland, Ukraine) by offering access in exchange for greater alignment. The UK would like to maintain full access and is offering less alignment in return, at least in some areas. Nothing comes for free in trade negotiations and the problem I have in suspending my disbelief in considering a bespoke solution to the EU-UK relationship is that I’m struggling to see how these negotiations will result in either a major breach in the integrity of (and the EU’s control over) the single market, or a solution which involves such a democratic deficit and sub-optimal outcome for the UK that we would be better off in the EEA where we would retain some indirect influence.

[1] Of course the objective of the second phase of Brexit negotiations is not on the future trade relationship per se, but on finalizing the UK’s withdrawal agreement. However, the future trade relationship will have to be taken into consideration as per article 50
[2] One important issue which I do not focus on in detail here, but which will condition the final agreement and the discussion of the future trade relationship is how to keep a frictionless border within the island of Ireland. With the UK deciding to leave the CU and the ESM this has made this an almost impossible problem to solve. As many commentators have recognized it may well ultimately affect the type of Brexit the UK can opt for. The commitments made by the UK and the EU in the phase I negotiations are set out very clearly in the agreement (see European Commission COM(2017) 784 final)
[3] In recent estimates, Ebell estimates that a UK move from the ESM market to FTA with EU will involve a 35% fall in goods exports and a 61% in services exports
[4] An exception was the abortive Transatlantic Trade and Investment Partnership offer by the EU to the USA

Anton MuscatelliAnton Muscatelli | Twitter

University of Glasgow

Prof Sir Anton Muscatelli is Principal and Vice Chancellor of the University of Glasgow. He is Chair of the First Minister of Scotland’s Standing Council on Europe and Advisory Board Member of the Scottish Centre on European Relations.