26 May 2022

A new windfall tax would trade long-term investment for short-term headlines

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You can’t make things cheaper by increasing taxes on them. This should be obvious, but the logic appears to elude large parts of Parliament who appear to believe that redistributing the cost of living is the same as reducing it.

Labour proposed a windfall tax on the North Sea to fund targeted welfare support in January, some Conservatives have made similar noises, and the Financial Times believes the Treasury to be considering wider measures on renewable generators. The welfare elements to the proposals are uncontentious – targeted support does help and is the most efficient way to provide poverty relief to those in need. These windfall taxes, however are populist gimmicks that trade long-term investment in energy solutions for short-term headlines.

The case for a new tax on the North Sea is particularly weak. There is already a windfall tax on UK drilling activities, the North Sea Fiscal Regime, that applies a special corporation rate of 40% to all ringfenced profits. That’s 21 points higher than the 19% paid by all other corporates, and the OBR estimate it will bring in about 800% more tax to the Treasury between 2021-25 than the previous six years.

A £21bn tax surprise is a windfall by any estimation and the starting point for anything the Government may wish to do on welfare spending. Labour’s proposal in substance was to raise it to 50% for one year to yield £1-3bn (their numbers keep changing). A rounding error difference in windfall gains, but a very negative investment signal to drillers who have repeatedly said that tax stability is more important that tax rates when it comes to supporting investment. Norway, for example, has much higher tax rates than the UK but hasn’t changed them for 20 years.

The UK, conversely, has tinkered every time there’s a shift in the global oil price. Labour introduced a 70% rate in 1975 (different tax) and the Conservatives a windfall addition in 1980. Both measures precipitated falls in investment and a long period of stagnation in the 1990s. Labour reformed the scheme to the current regime in 2002 at today’s rate of 40%, but bumped it to 50% in 2006, again causing investment declines, before George Osborne took it up to 62% in 2011, causing a substantial collapse. He was compelled to introduce new field allowances and reduce rates back to 40% to restore investor confidence. Meanwhile the Treasury was left paying out negative taxes to the industry in 2015/16. To look at that record and believe the thing to do now is repeat the exercise, amid a supply crisis, is the definition of madness.

Oddly, the case for a tax on renewable generators is stronger but still ill-advised. A bad windfall tax is one that is imposed for entirely arbitrary reasons, such as doing well from exogenous trends beyond your control. This is the case with global commodity prices such as oil and gas. If that approach is taken, no investor can feel safe putting money into your jurisdiction. Why not, for example, a ‘Zoom tax’ on pandemic profits, or ‘Tesla tax’ on people liking electric cars, and so on. These are banana republic tax policies.

A more reasonable proposition is to correct windfall gains from policy errors made by the Government. This was the case with the second Thatcher windfall tax on banks, where the case was made on the grounds of correcting the error of 17% interest rates in 1979, back when interest rates were set by politicians.

That logic applies directly to the supernormal profits currently being enjoyed by any renewable generators utilising the Government’s Renewables Obligation scheme, about 80% of the capacity on the grid. The RO was ditched in 2017 but will be paying out until 2037. It is complex, but in essence means the generators get the wholesale price (i.e. gas generation price) of electricity plus a very generous subsidy. Pre-crisis they enjoyed returns of 30-50% on their renewable divisions, today that looks more like 100%+. A huge windfall gain due to global gas prices and poor policy design. There is a very strong case to at least remove the subsidy if not tax the profits.

The newer scheme (Contracts for Difference) attempts to correct this, in theory requiring generators to pay back any gains above a contracted strike price. But the generators on the scheme operational today enjoy high prices (£95-177/MWh), while those that could be cheaper (£47/MWh+) have either not yet been built or, like Moray East, are exploiting a loophole to defer the scheme until prices rise. It’s become a one way bet in which the generator always wins and the poor billpayer picks up the tab.

It is, however, not the generators’ fault that the Government are making unwise promises through bad policies, and there will clearly be a negative impact on renewables investment if the state arbitrarily rips up or changes contracts. This isn’t just theory, the merest threat to do so this week caused the stocks of several generation companies to fall up to 10%, wiping billions off their valuations.

If investment in renewable energy falls, the low carbon transition will take longer. If investment in oil and gas fall, there will be fewer domestic resources and the taxes on them to pay for it. If both those things happen our bills are going up and staying up for far longer than might otherwise be the case. The Government would be wise to stick to their guns and avoid funding welfare by demonising a particular industry.

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Columns are the author's own opinion and do not necessarily reflect the views of CapX.

Columns are the author's own opinion and do not necessarily reflect the views of CapX.