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Windfall taxes are unpopular with some, including Lex. True, when companies are making extraordinary — and unexpected — profits, temporarily lopping off a slice does not skew the market all that much. Raising such levies when there isn’t much of a windfall to tax, however, is a much trickier proposition.
That is the situation the Labour party finds itself in as it lays out its policy for North Sea oil and gas production. Its manifesto pledges to raise the windfall tax rate by 3 percentage points to 78 per cent. It also promises to remove “unjustifiably generous” investment allowances. The local oil and gas industry — whose shares have taken a nose-dive — has responded by warning that this plan will kill off investment in the sector. Such squeals are predictable. This time, however, they will not be far off the mark.
In fairness, raising the headline tax rate makes little difference to the companies involved. It would also raise precious little tax revenue — in the region of £500mn a year.
The real debate concerns capital expenditure allowances. These enable companies to include their investments in future projects in the basin within their cost bases. This means that the headline tax rate is applied to a much smaller residual profit. The idea is to give companies an incentive to invest, as well as providing them with reasonable cash flows with which to do so, and if possible return some money to their investors.
Fiddling with such allowances without harming investment is not easy. Already, the North Sea is not a particularly compelling place to do business. In Norway — where operating and investment costs per barrel are around half of those in the UK — companies generate post tax cash flow above 140 per cent of investments, according to Christopher Wheaton at Stifel. Even under the current tax regime, post tax cash flow generated in the UK North Sea is just over 60 per cent of capex costs, and might be more than halved if investment allowances are cut.
That would further reduce the UK’s competitiveness when it comes to attracting capital. In absolute terms, the economics of individual projects might yet stack up — especially if producers believed that come 2029 the windfall tax regime will be rolled back. But with increases and extensions to the tax regime coming thick and fast, optimism is a commodity in short supply.