Recent events in the global political economy have led to record high increases and levels in the prices of oil and gas and their derivative and associated products.
The most important political economy factors causing this price trend, which is a manifestation of the imbalances in global supply and demand of petroleum products, have been (1) the Russia-Ukraine war which commenced in February 2022, with the resulting geo-political sanctions by the United States and its western allies on Russia’s energy exports; (2) recovery in global oil demand following the uplift of COVID-19 lockdown restrictions in many countries, and the resulting recovery in economic activity; (3) a swift decline in global oil and gas inventory levels following cuts in OPEC+ supply; and so on.
The record high increases and levels in petroleum prices have led to (1) a cost-of-living crisis in many countries including the UK; and (2) a significant increase in profits earned by the upstream petroleum sector globally, including that of the UK Continental Shelf (UKCS). UK inflation as of August 2022 was at a 40-year high rate of 10.1% hence squeezing the real income levels of UK households (see ONS). At the same time, the net rate of return of UKCS companies had increased from -5.9% in Q4 2020 to 18.1% in Q1 2022 (see ONS). To help fund a cost-of-living support scheme for UK households, the UK Government in May 2022 introduced a new upstream petroleum taxation regime, which included the imposition of a new Energy Profits Levy (see UK Government, 2022). This levy, effectively a windfall tax, surcharges the price-induced windfall earned by the upstream petroleum sector in the UKCS, at a rate of 25%. This is in addition to a pre-existing Ring Fence Corporation Tax rate of 30% and a Supplementary Charge rate of 10% on profits. The headline rate of tax in the new UK upstream windfall taxation regime is therefore 65%, compared to the previous taxation regime’s headline rate of only 40%. With the new windfall taxation regime, the UK Government hopes to raise about £5 billion (i.e. circa $6.31 billion) from the upstream UKCS sector in the first 12 months of implementation to fund its cost-of-living support scheme.
Recognising the potential negative effects of the new windfall tax on planned and/or prospective future upstream UKCS investments, the UK Government introduced a new super-deduction style 80% investment allowance for UKCS operators as part of the tax relief incentives in the new windfall taxation regime. Operators would be able to offset some of the burden of the new windfall tax by applying this allowance to reduce taxable windfall profits. The introduction of the new investment allowance nearly doubles the tax reliefs available to operators in the new windfall taxation regime relative to the previous taxation regime. The UK Government contends that the higher tax relief package in the new windfall taxation regime would encourage operators to (re)invest in the UKCS sector, leading to more UKCS jobs, greater UK energy security and wider UK economic growth.
The new UK windfall taxation regime took effect on 26 May 2022. The UK Government has indicated to phase out the windfall tax when petroleum prices return to historically more normal levels. Legislation for the new windfall taxation regime includes a sunset clause for 31 December 2025 at which point the windfall tax would cease to be in effect. This effectively makes it a three (and half) year temporary fiscal measure.
Upon the introduction of the UK windfall taxation regime, some industry stakeholders have posited that the tax would diminish the value of UKCS fields hence causing projects to be economically unviable and leading to a reduction in the competitiveness of the province. The Oil and Gas UK (OGUK), which is the leading representative body for the UK oil and gas industry, have said the windfall tax “would damage competitiveness, and discourage energy companies from investing in the UK” (see OEUK).
In my latest research, I develop an optimal investment appraisal model that fully incorporates all instruments of the new UK windfall taxation regime. There are currently twelve UKCS oil and gas fields undergoing the administrative processes set by the UK Government leading to their development and subsequent production. All twelve fields are projected to be developed in 2022 or later; and are expected to have struck first oil and/or gas production in the next few years. I consider these fields because they are fully subject to all the handles of the new UK windfall taxation regime only. The twelve fields in question are broadly representative of the characteristics of the breed of new fields being discovered and developed in the mature UKCS province.
I find that the UK windfall tax does reduce field economic value. However, the extent of the reduction is marginal in most cases and therefore insufficient to cause fields to be uneconomic. The tax more generally is hence unlikely to cause premature abandonment of sufficiently prolific new fields in the UKCS. Consequently, the tax would not irredeemably injure the global competitiveness of the province. For the UK Government Exchequer, the windfall tax would raise about $341.60 million from the twelve new fields under consideration in my study. Finally, the UK Government indicates to phase out the windfall tax when oil and gas prices return to historically more normal levels. These levels have however not been specified in the underpinning legislation. I show the critical oil price levels required for all fields to be economic. My analysis on critical oil prices may be used by the UK Government as a guide to trigger an accelerated phase out of the windfall tax should oil prices slump. This would help maintain the global competitiveness of the UKCS province. A working paper version of my paper is available to download here.