Taxing times for the UK Oil and Gas Industry

The last couple of weeks have seen furore from the UK oil and gas industry following the Chancellor’s statement on Monday 29^th July which included an increase in offshore oil and gas taxes. This has included heated statements from David Whitehouse, CEO of the industry body Offshore Energy UK, and David Latin, Chair of Serica Energy, a UK focussed oil and gas company. The industry response does appear to have encouraged the government to engage further with the Treasury Minister James Murray visiting Aberdeen on Monday.

You may think the industry reaction is the standard response to increasing taxes from the government. You may also think that this is ‘big oil’ and hence they deserve to have ‘windfall taxes’ imposed on them. Indeed, last week Shell announced profits of £4.9 billion for the first quarter (yes, the first quarter) of the year.

However, the debate is a lot more nuanced than the headlines and hence it is worth drilling down (pun intended) to the next level of detail.

The headlines are that the UK Government, which has governance of all oil and gas production in UK water, is increasing the Energy Profit Level from 35% to 38% and extending the tenure to 2030. The EPL was originally implemented by the Conservative government in July 2022, for a limited time, as a ‘windfall tax’ on the oil companies. The EPL is in addition to the upstream (ie offshore oil and gas revenues) Corporation Tax rate of 30% plus a Supplementary Charge of 10% giving a new total tax rate of 78% compared with the standard UK corporation tax rate of 25%. Upstream taxes are ‘ringfenced’ to the offshore operations and hence profits cannot be offset against expenses in other parts of the company’s business (for example construction of windfarms). The increase in the EPL will take the overall tax rate to the same as Norway which is a comparison the government often makes. What worries the industry more than the headline rate of tax however is the proposed, but not fully clarified, changes to capital allowances. Capital allowances are a standard mechanism across all industries in most countries whereby companies offset investment costs against profits.  The Labour manifesto described changes to capital allowances as ‘closing loopholes in the windfall tax’ and the Green Party and others describe the allowances as ‘subsidies’. However, the ability to claim costs, whether operational or capital, is a fundamental principle of the tax regime and is absolutely not a ‘subsidy’.

To be clear up front, these UK tax changes will have minimal effect on the likes of Shell and BP as the vast bulk of their earnings come from international operations. The hardest hit will be a number of small to mid-size, UK focussed companies. These companies, including Harbour (the largest UK producer), Serica, Ithaca, NEO Energy and Enquest, are not household names but are the ones at the forefront of the UK oil and gas industry as the majors withdraw from the North Sea or focus on a few key fields. Just last week Shell and ExxonMobil announced the sale of their remaining fields in the Southern North Sea and Netherlands to Viaro. This leaves ExxonMobil with no presence in the UK offshore.  Likewise Chevron are looking to exit the area. Although the other supermajors, BP, Shell and Total, retain production in the North Sea, their portfolios are very focussed, a long way from their dominant positions in the past and almost insignificant in terms of their overall business. The recent sale of fields continues the trend of of the last 25 years of oil and gas fields being transferred to smaller, more dynamic companies entirely focussed on the UK. Changes to the tax regime disproportionality affect them.

The announcement has two direct impacts. Firstly, the increase in tax and reduction in capital allowances makes any investment, be that a new field development or additional drilling or upgrades in an existing field, less economic.  Secondly, the lack of clarity on capital allowances leads to uncertainty which inevitably means that projects will be delayed. These effects will mean that there will be less investment in UK offshore, leading to lower production and lower tax revenues- the opposite effect of the government’s aims. This will inevitably lead to an acceleration in decommissioning of existing fields as incremental investment will not happen and new fields will not be tied back to existing platforms.  Accelerated decommissioning will result in steeper decline in oil production and increased government costs to cover the tax allowances companies can still claim. Taken together, these effects will likely reduce the Government’s tax take- the opposite of what they are hoping to achieve. Although green groups may applaud the speedier demise of North Sea oil and gas production, the stark fact is that this will be replaced by oil and gas from elsewhere rather than by greener alternatives.

There will also be a huge impact on the number of people employed in the industry- currently 200,000 people in the UK with some 70,000 in Scotland. Of course, the government asserts that these people will be able to transition to renewable energy. While there are undoubtably synergies between the two sectors, and many companies invest in both, the rate of decline in the oil and gas sector caused by these tax changes means it is very unlikely that the ‘just transition’ touted by government will come to pass. Indeed, a rapid decline in the oil and gas sector could irreparably damage the supply chain with a direct impact on the renewables sector.

The oil and gas industry has made an additional claim regarding security of supply and carbon emissions. Oil and gas currently provides 74% of current UK total energy consumption, less than half of which is supplied from the North Sea. Even on a NetZero scenario, oil and gas will still account for 25% of UK total energy consumption by 2050. The industry argues that increased North Sea production will lead to improved security of supply. This effect is only marginal for oil, 80% of which is exported, due to the capacity of UK refineries.  A stronger case can be made for gas, most of which is used in the UK, and this situation would strengthen if the UK had more gas storage capacity. The reopening of Rough gas storage in 2022 and planned expansion of the facility will help in this regard. As both oil and, to an increasing extent, gas are commodities priced on an international market, increasing UK supply will not reduce costs for UK consumers.

In terms of carbon emissions, I have previously written about the misleading information from former Conservative ministers and various industry bodies. Firstly, the vast bulk of carbon emissions from oil and gas are related to burning the fuel not from the production, transportation and processing of the fuel.  Secondly, carbon emissions from imported Norwegian and other imported piped gas (which accounts for about 40% of our gas consumption) has equivalent carbon emissions to domestically produced gas. Imported LNG does have significantly higher carbon emissions related to transportation which would be reduced with increased domestic production. Finally, new fields generally have lower carbon emissions related to production. Therefore, there is some positive, albeit minimal, impact in having domestically produced oil and gas from new fields.

I can imagine many people, outside the industry and north east of Scotland, applauding the proposed tax changes given the likely impact of reducing domestic oil and gas production.  There are people who think we can instantly turn off our need for oil and gas and rely solely on renewable energy. However, this is naïve in the extreme. Scotland does generate most of its electricity from low carbon sources, including nuclear, but electricity only provides 22% of the country’s energy needs. Transport, domestic heating, public heating, industry, the chemical industry all still reply on oil and gas and will do for many years. The current choice is not between fossil fuels and renewable electricity but between domestic oil and gas supply and an increasing proportion of international supply.

Stuart Paton is an energy industry advisor and former Chief Executive of Dana Petroleum. He is also an associate of Reform Scotland