Levy on exceptional profits seen as having little impact on oil and gas sector’s investments in renewable energy sources.
The Concise Oxford Dictionary offers two definitions of “windfall”. One is “an apple or other fruit blown from a tree by the wind”. The other is “a piece of unexpected good fortune, especially a legacy”.
Not much, or indeed any, mention of profits accruing from Russia’s invasion of Ukraine, or from a general surge in energy prices. But the underlying premise remains the same, that a windfall is something unearned, resulting from luck rather than individual or corporate efforts.
And such a “piece of unexpected good fortune” is seen by many as fair game for special tax treatment. After all, the beneficiaries did nothing to deserve it, thus won’t notice – or at least resist – if it is taken away, in part or in whole.
A hot political topic
Since Russia’s invasion of Ukraine in February, energy markets have been severely disrupted and fuel prices have shot up, leaving oil and gas firms with rocketing profits, including Saudi Arabia’s Aramco, which recently reported quarterly profits of US$48.4 billion. On 28 January, natural gas futures were trading at US$4.26 per metric million British thermal units. By 17 August, this figure stood at US$8.97.
Brent crude, a benchmark used in more than half of all oil contracts globally, stood at US$87.37 a barrel on 28 January and shot up to US$120.86 a barrel by 7 July – before settling back to US$95.40 on 16 August.
Oil’s partial retreat owes more to fears about growth in the world economy than to profit restraint among energy companies, while soaring gas prices have become a hot political topic in Britain and Europe as thoughts turn to winter and the likely impact of heating bills on domestic budgets.
Then there is the over-arching question of how such taxes fit in to the universally accepted need for the world economy to move to a net-zero position. If the proceeds are channelled to renewable energy projects, infrastructure renewal, energy efficiency initiatives, or research and development, windfall taxes could serve to accelerate the low-carbon transition. But critics have argued that they could stifle investment plans by affected firms, slowing down efforts to transform their business models through investment in renewable energy assets.
In the current landscape, windfall taxes become increasingly attractive. After all, the extra profits made from these price rises did not result from investment by shareholders, ingenuity on the part of management or heroic efforts by employees. They are entirely fortuitous and, for those with a taste for moral indignation, arose in part from the agonies suffered by the people of Ukraine.
Indeed, the UK has already imposed a windfall tax, raising £5 billion, although to avoid looking as if he were responding to calls from Opposition MPs, the then Chancellor Rishi Sunak called it something else. Now, the Labour Party is demanding the levy be extended to fund help for families with their energy bills beyond what is already in place. There is also potential for the scope of the tax to be extended to energy utilities.
The case against
Windfall taxes, it seems, are the flavour of both last month and this. What’s not to like?
To begin with, there is a respectable case against “surprise” taxation. Investors, especially foreign investors, value predictability in fiscal matters and their financial calculations are greatly helped by having a rough idea of what tax they will be asked to pay in future.
Then there is the unarguable fact that energy companies took a beating during 2020 and 2021 as coronavirus-related lockdowns paralysed economic activity across the developed world. Few were suggesting public subsidies to such businesses, so, it can be argued, today’s profits are simply recompense for the earnings squeeze created by the actions of governments.
Finally, windfall taxes may take money that energy companies may have planned to invest in renewable and low-carbon power sources. That would mean a net loss for cleaner energy, given that even if governments used the revenue to invest in such activities, of which there has been little mention, there is a fair reason to assume they would do so less effectively than energy professionals.
Maria Chiara Caviggioli, Analyst at Moody’s Investors Services. said of the British Government’s decision to impose a 25%windfall tax on oil and gas producers: “Although the new levy is credit negative for the UK oil and gas sector as a whole and introduces uncertainty over investment decisions, we expect the large integrated oil and gas companies that we rate will be less affected by the rise in tax payments compared with smaller more geographically concentrated exploration and production producers exposed to the UK Continental Shelf.”
Little evidence of investment in renewables
Caviggioli added: “Although difficult to predict how much incremental tax will be payable by each oil major, rising tax payments weaken metrics and result in reduced surplus cash flow available for shareholder remuneration or debt reduction. However, 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 in line with the companies’ capital allocation policies, thereby limiting the impact on our metrics.
“Moreover, these companies are highly diversified and with other operations that can help mitigate the effects, and the UK is only one of many markets. Accordingly, metrics will remain robust for large integrated oil and gas companies.”
Professor Trevor Williams of Derby University and former Chief Economist at Lloyds Bank said: “One-off taxes on windfall profits should not damage the energy industry. They merely divert money that the companies concerned did nothing to earn, hence the name.”
There was, he said, no evidence that oil and gas companies had used the revenues now subject to the windfall tax to invest in renewable energy sources. “It was being spent on shareholder dividends and management bonuses.”
Holly Duhig, a spokesperson for Uplift, an organisation campaigning for a fossil-free UK, said: “Claims from oil companies that a windfall tax diverts money that would be spent on renewable energy is greenwashing nonsense and a complete misrepresentation of industry spending. The vast majority of North Sea operators invest nothing in UK renewables and, when they do, it is often to power their own planet-destroying oil production.”
“A scandal over time”
Duhig added: “The decarbonisation plans of UK oil and gas companies are woeful, lagging far behind the Climate Change Committee recommendations. Investors need to stop believing that these companies are a key part of the energy transition; they can’t and won’t change their core business model.”
A proper transition, she said, will require clear government ambition that would put a stop to the cost-of-living and the climate crisis. “We desperately need a fast transition away from oil and gas and towards, greener, more affordable energy.”
One industry insider, speaking on condition of anonymity, said: “The business models of many oil and gas companies have completely changed during the last decade. Cash has been passed to investors rather than being used for investment, especially in cleaner energy.
“Such investment in renewables as exists is often just PR. The industry knows that what can be called its social licence to operate is hanging by a thread.
“UK windfall taxes may have taken 18% out of the sector’s free cash flow but the industry is still making very large profits, little of which is being invested in low-carbon energy or renewables.”
He added: “The tax system provides very generous oil and gas allowances that will become a scandal over time.”
According to the International Energy Agency, the percentage of industry capital expenditure being invested in renewables was 4% in 2021, up from 1% the previous year. Last year, the World Benchmark Alliance published a report highlighting low levels of disclosure around capex allocated to the development of low-carbon and mitigation technologies.
Academic research published this week found that decarbonisation scenarios developed by oil majors are inconsistent with the objectives of the Paris Agreement.
Windfall wisdom questioned
Others took a different view, partly on grounds of the potential added uncertainty to the investment environment. Andy Mayer, Energy Analyst at free market think tank, the Institute of Economic Affairs, argued that windfall taxes are “rarely wise” and are usually justified to correct gains from policy error rather than pure market fortune.
He added: “They discourage investment, doubly so if investment relief is removed. A folly when the issue is shortage of energy supply.”
John MacDonald, Director of Strategy at the Adam Smith Institute, another pro-market think tank, warned against raising or extending the UK windfall tax, saying that “hiking up a supposedly ‘one-off’ windfall tax” just months after it was introduced would add “to business uncertainty at a critical time for the UK economy”.
It also would not “help households being slammed with rapidly rising bills”.
The trade body Offshore Energies UK, representing more than 400 companies in the sector, said the levy risked driving away investors and undermining the UK’s future energy security. Chief executive Deirdre Michie said that she was disappointed that the levy had become law and urged ministers to work with the industry to minimise the damage done to it.
She said: “The UK’s oil and gas operators were already paying a 40% tax rate on profits from oil and gas production on the UK Continental Shelf (North Sea). Under the new law, the UK’s offshore oil and gas operators must pay an additional 25% tax on UK oil and gas profits.
“This means the combined rate of tax is now 65% by far the highest tax rate faced by any business sector”, she said.
Such a rate is a worst-case outcome, and allowances and other reliefs may mean the real figure paid is, in many cases, markedly lower. Under the Energy Profits Levy announced in May, an Investment Allowance offered energy companies tax savings of 91p in the £1 on investments in fossil fuel extraction in the UK. Further, oil majors such as Shell and BP have been able to structure their tax affairs to pay very little UK tax in recent years.
Windfall taxes are not unknown, either at home or abroad. Margaret Thatcher’s government in the early Eighties levied one on the profits gained by banks as a result of very high levels of interest rates, imposed to fight inflation, and Labour in 1997 levied a windfall tax on public utilities to fund the “new deal” training scheme for young people.
To end where we began, with the Concise Oxford Dictionary, which defines a windfall tax as being levied on “an exceptionally large profit, especially one regarded to be excessive or unfairly obtained”. Whether or not the recent gains of the energy companies are either excessive or unfair is ultimately a political decision.