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Tilting at windfall taxes (part 2)
UK government’s bid to claw back profits is riven with dubious trade-offs
“The energy industry is often painted as the villain, but clawing back excessive earnings made at the expense of consumers is easier said than done.” – Energy Flux, January 2022
These are extraordinary times, with the energy world whipsawing from unprecedent pandemic-era blood-letting into a troubled new wartime era of structural shortages, higher prices, frenzied profit-making and profound investment uncertainty. The political response – to redistribute excessive profits to fund consumer subsidies at a time of deep crisis – has an economic and moral logic to it. But windfall taxes are rarely a good idea. They are an admission of failure to adequately regulate a free market. The British government’s attempt to reset the risk-reward balance pursues short-term political objectives at the expense of longer-term investment certainty — at the worst possible time for the energy transition.
Populist pressure to take action against headline-grabbing energy profits has been mounting for months. The UK Treasury finally caved and imposed an immediate 25% surcharge on “extraordinary” oil and gas profits on 26th May.
The Energy Profits Levy is intended to raise “around £5 billion over the next year” towards a £15 billion package to help struggling families with the UK’s spiralling cost-of-living crisis.
Taxing ‘fat cat’ energy companies to fund social programmes is always wildly popular with the electorate and terrible for investment. The levy seeks to ameliorate the downside by offering an 80% ‘super-deduction’ against investment. This equates to a 91p tax saving for every £1 invested and effectively reduces the 25% levy to 5%.
The super-deduction is redeemable immediately at the time of signing big cheques – not five years later, when revenue starts flowing. The idea is this will spur immediate investment and convince hesitant oil companies to splurge on new field developments.
That’s because they will not be able to carry forward losses or offset decommissioning expenditure against profits subject to the levy. The only escape route is to reinvest in more drilling. Whether this results in a net increase in investment is not yet clear, because extracting the remaining resources in declining North Sea fields is becoming increasingly expensive. It is too early to tell.
What is clear is that companies with existing North Sea capital programmes are sitting pretty. Serica Energy, a medium-sized North Sea gas producer, confirmed on Monday it won’t be liable to pay much extra tax thanks to its North Sea investment plan:
“Our planned 2022 expenditure on the North Eigg well and the LWIV campaign is around £60 million which we expect to be eligible towards this tax saving. This will offset a large element of the Energy Profits Levy that would otherwise be payable on Serica’s profits this year.”
Serica issued this statement after its share price crashed 40% from mid-April peak as the market weighed up the likelihood of a swingeing windfall tax, then digested the detail of the levy. The statement — issued on 6th June — had the desired effect of reversing some of those losses:
Stocks in fellow North Sea independents EnQuest, Ithaca Energy, Harbour Energy and others wobbled too, because undiversified geographically-focussed small and mid-sized operators are most exposed to the UK fiscal regime. Their windfall tax liability will depend on their investment plans.
Big players pony up
European international oil companies (IOCs) such as BP, Shell and TotalEnergies still dominate hydrocarbons production on the UK Continental Shelf (UKCS), but their diversified portfolios can more readily absorb the levy. The UK is only one of many markets for IOCs.
The levy’s two main short-term objectives – stimulate North Sea investment and raid corporate coffers to throw money at families in financial hardship – are mutually exclusive. The more investment that is made, the less new money the tax will raise for redistribution, and vice-versa.
The opposition Labour Party seized on this, with shadow chancellor Rachel Reeves telling parliament:
“How can the minister be sure how much this new levy will actually raise when the chancellor has added this gigantic get-out clause?”
The bottom line is that the levy will raise some new money from a sector that has paid very little back the exchequer in recent years.
“Interestingly, in the last few years only 35 oil and gas groups have paid any corporation tax because of losses and decommissioning allowances, with the top seven of these responsible for 95% of all tax payments.” – Andrew Terry, Keystone Law
Moody’s Investors Service said in a briefing note that much of the excess cash flow from high hydrocarbon prices is “currently being allocated towards shareholder remuneration such as share buybacks, which can be scaled back”. Even the exposed independents should be able to afford it. “Most companies have already strong metrics given currently high hydrocarbon prices, which will help mitigate the effects of rising tax outflows,” Moody’s said.
The big trade-off
The political motive for taxing windfall profits is more cynical. The Conservative administration of prime minister Boris Johnson seemed to use the levy announcement to distract from a worsening leadership crisis (which shows no signs of going away). The opposition, which wants a much more onerous and enduring North Sea tax regime, has of course sought to capitalise on this too.
Less discussed is that all of this short-term thinking comes at the expense of fiscal certainty, which affects the much bigger prize of capital allocation in the energy space. As usual in British politics, we are seeing short-termism and political expediency win out over effective longer-term energy policymaking.
Another way to look at it is fiscal policy being used to put energy security ahead of the energy transition. Waving a big tax stick to gamble on a quick uptick in upstream oil and gas investment sends the message that future clean energy investments could be at risk.
The mainstream debate around the windfall tax loophole has focussed on whether producing more North Sea oil and gas is a good idea. Considering the “Russia-sized hole” in global oil supply, that argument seems more one-sided than usual.
More contentious is whether undermining investor confidence in the UK energy fiscal regime is a price worth paying when gargantuan investment sums are needed to decarbonise the UK economy. Serica CEO Mitch Flegg reminded policymakers of the very long lead times on energy investments, and called for them to:
“consider the importance of fiscal stability in … sustaining investment in the UKCS at a level capable of ensuring security of oil and gas supply in volatile markets and delivering energy transition targets.”
More intervention looms
This is not just about oil and gas. The Treasury has been clear from the start that, while the levy won’t apply to power generation, certain parts of this sector have also seen “extraordinary profits”. Policymakers are chewing over what to do about it.
UK chancellor Rishi Sunak said on Monday the Treasury is “urgently considering the case to extend that levy to the electricity generation sector”, and is talking to industry to “understand the scale” of windfall profits being enjoyed from zero marginal cost power sources.
“That is a result of how the market works, which is the price of electricity being set at the marginal supplier—which at the moment is natural gas, at these very elevated levels—so there will be lots of people whose costs of producing electricity are much lower than that. That is where these excess, or extraordinary, profits arise.”
The challenge for the Treasury is to ensure the cure is not worse than the disease. As detailed previously in Energy Flux, it is not easy to pinpoint where excess profits are being made: by wind farms receiving fixed subsidy payments that don’t respond to commodity price movements? By traders that buy wind power under fixed-price power purchase agreements (PPAs) and sell for a huge mark-up? Or by industrial offtakers that shut down energy-intensive operations to resell their green PPAs in wholesale markets?
Not really a taxation problem
Fiscal certainty will be key to achieving the government’s own objective to drive an “unprecedented £100 billion of private sector investment by 2030” into Britain’s clean energy industry. This calls for a swift and surgical intervention that somehow disentangles complex ownership structures and avoids stranding sunk investments made in good faith.
Fiscal intervention is probably not the best tool here. An easier option is to draw a line under past windfall electricity profits and focus on reducing excessive future wind farm payments. The way to do that is to address the root of the problem: problematic legacy energy regulation.
As regular readers will recall, the Contract for Difference (CfD) is doing a grand job protecting consumers. Sadly, most wind farms are still on the old Renewables Obligation (RO), which pays a fixed subsidy on top of the (ballooning) wholesale electricity price. One solution would be to end the RO and put wind farms financed under that regime onto fixed contracts that shield them from wholesale price movements.
For example, this could be £50 per MWh for the wholesale electricity costs, plus a value for the RO incentive they were receiving previously. With wholesale power trading at between £150 and £200 per MWh and forecasts of prices remaining elevated for the rest of this decade, this measure could save consumers an estimated £140 on average per year.
Some things can’t be rushed
The British government has shown it is prepared to make big interventions, but regulatory reform is a slow-burn process. The energy department (BEIS) initiated a review of electricity market arrangements (REMA) in its Energy Security Strategy that is broad in scope and promises take a long time to implement. Sunak says this is now a matter of urgency for government, but expediting complex interventions risks baking in more structural mistakes.
The complexity of some of the solutions being given serious consideration – such as locational/nodal pricing for power generation – will have far-reaching implications with unintended consequences that are hard to model, predict and therefore to avoid. I will dissect these in more detail in a future post.
For now, the takeaway on windfall taxes is this: there is no free lunch, and the energy sector needs long-term certainty now more than ever. The scale of investment required to achieve looming climate targets has never been greater, and addressing the ‘trilemma’ of affordability, security and emissions has never been more difficult.
Decarbonisation means the energy sector will increasingly be dominated by capital-intensive assets. So populist measures that drive up the cost of capital will ultimately cost consumers much more, which undermines the whole rationale for redistributing windfall profits.
Seb Kennedy | Energy Flux | 8th June 2022