The pros and cons of an upstream windfall tax

Upstream oil and gas companies are making money; a lot of it. Record Q1 2022 results show just how much: earnings, cash generation and shareholder distributions are at levels unimaginable two years ago. High oil and gas prices have breathed life back into the sector, not least in the stock market. Unfortunately, it’s not a good look during an energy and cost-of-living crisis.

Whenever a price spike generates windfall profits, the threat of fiscal disruption soars. Politicians are debating windfall profits taxes across the world, and the UK is understood to be on the cusp of announcing an increase in its North Sea tax rate. Graham Kellas, Head of Fiscal Analysis, and Neivan Boroujerdi, Director of Upstream Research, shared their thoughts with me on the arguments for and against.

First, while oil prices regularly rise and fall sharply, natural gas prices have also risen in this cycle to record levels. It’s these high gas prices that have had a much greater impact on electricity prices and household heating bills, driven up the cost of living and led to demands for government support. In the UK, some renewable projects (though not all) receive the higher market power price, so a windfall tax might also be extended to electricity generators that are making windfall profits.

Second, many countries, including big oil and gas producers Brazil, Nigeria and Canada, already have mechanisms in place that automatically change the tax or royalty rate when prices change. UK policy over the past 50 years has also been to adjust the tax rates when prices change, but on an ad-hoc, unpredictable basis – which investors abhor. We understand the proposed tax change will be more of the same, possibly limited to a specific period. A bolder response from the government would be to link its petroleum profits tax rate, the supplementary charge (SC), directly to prevailing oil prices. This would give investors the fiscal predictability they demand.

Third, the UK industry is telling the government that it does not need to increase the tax rate as the current system is already doing its job. In the seven years to 2020/21, when Brent averaged US$55/bbl, official government estimates show North Sea tax revenue averaging less than £1 billion a year. Last year, tax revenue was £3 billion as oil and gas prices rose and will reach £8 billion this year with Brent approaching US$100/bbl. If gas prices stay at stratospheric levels, the tax take could be in double figures in 2023, close to the record government revenues of early this century.

Based on government figures, the anticipated increase in the SC rate from 10% to 20% could redistribute a further £2 billion to the Exchequer this year. The North Sea industry claims the higher tax will dampen the appetite to invest in the UK. It’s a very mature basin, with new projects under fire from protestors; what’s really required to maintain the UK’s competitiveness, it says, is a relatively low, stable tax rate. Any negative impact on investment would also come at a time when Europe is desperate for alternative sources of oil and gas supply away from Russia.

However, our analysis suggests the tax rate increase would not make any new projects uneconomic or result in the premature closure of any existing operations. It is also highly unlikely to result in companies exiting the UK that were not planning to do so already.

Finally, the UK government has resisted opposition calls in the past for the tax increase in the belief that companies would spend their windfall on new investment, and on green technology and renewable energy projects in particular. That’s not really happened at the desired pace, and the perception is that the companies are harvesting, not growing – hence, the higher tax.

We have highlighted the possibility of connecting petroleum taxes and new energy investment before. Maybe the time has come for governments, including the UK, to conduct a more radical review of the energy fiscal system, combining remaining oil and gas production with new, renewable energy supplies via a holistic energy fiscal policy.