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Levies on energy profits: can they solve the UK’s cost of living crisis?

The prospect of windfall taxes on the profits of oil and gas companies has gained support from the British public. But they are unlikely to solve the cost of living crisis alone, even after the recent expansion announced by the Chancellor of the Exchequer.

The underlying principle of windfall taxes is to redistribute profits that are unexpectedly and unusually high from the producers of energy to the consumers. The recent boost to profits is a result of the energy price surge and any redistribution would occur via reduced energy bills for households and firms.

But this ‘simple’ solution does not recognise that the proposed energy levies are unlikely to cover a large proportion of expenditure related to the cost of living crisis. This is because of the limited amount of money they would raise, as much would be absorbed by the generous allowances and reliefs available for energy companies.

Neither do these levies take account of possible unintended long-term consequences, which might include driving the UK away from its international commitments on climate change, lowering investor confidence and reducing employment.

To tackle the sharp increase in energy prices, the UK government has provided extensive support for all households. This comes primarily through a payment of £400 via the energy bill support scheme and a cap on energy prices in the energy price guarantee, valued at over £68 billion over two years (HM Treasury, 2022). But the uniform policy has been criticised for its lack of targeting to support the most vulnerable households (Adam et al, 2022).

The original plan was for this support to be offset partly by levies on energy producers. Initially, a windfall tax on oil and gas production profits was introduced at 25%, effective from 26 May 2022 until 31 December 2025.

After the mini-budget fiasco in September 2022, the new Chancellor of the Exchequer, Jeremy Hunt, was determined to reduce borrowing and increased the energy profits levy to 35%. He also extended the levy by three years and introduced the electricity generator levy with a rate of 45%, among other policies (HM Treasury, 2022).

What do we know about collections from these levies?

Data from the Autumn Statement 2022 suggest that these windfall taxes will nearly offset expenditure related to the cost of living support, with a resulting deficit of only £13 billion in the long term (see Figure 1).

Although the estimates are based on numerous assumptions, including highly volatile energy prices, they ignore the fact that energy prices and customer energy bills affect one another. From the costings, we could incorrectly assume that the energy producers would be experiencing exceptional profits up to 2027/28, but that customers will only need support up to 2023/24.

This implies a lack of fairness either towards energy producers or customers. If customers do not need support beyond 2023/24, then the energy producers are also unlikely to have exceptional profits, so taxing them seems unfair.

Figure 1: Costs related to energy support package and forecasted collections from levies, £ billion

Source: Autumn Statement 2022

Further, the expectations of high collections from the energy profits levy do not align with historical tax receipts. The companies operating in the extraction of oil and gas are currently liable to pay ‘ring fence’ corporation tax at 30% and supplementary charge at 10%. From 26 May 2022, they have also paid the energy profits levy at 25%, which will increase to 35% from 1 January 2023.

These three distinct taxes broadly follow similar principles and are based on the ‘ring fence’ concept, separating the extraction of oil and gas from other activities such as investments in renewable energy (Matikonis, 2022).

This prevents taxable income being reduced by losses from other activities or among these taxes. It means that historical losses cannot be offset against profits subject to the energy profits levy.

This convoluted system also includes numerous allowances. The most extensive are decommissioning relief, and capital and investment allowances.

To understand the extent of these, consider a simple scenario in which a company invests £100 million in further oil and gas extraction. It would get £75 million relief from ring fence corporation tax, supplementary charge and the energy profits levy, a further £6.25 million allowance for supplementary charge once investment starts generating income and an additional £10.15 million energy profits levy allowance to offset future profits – a total of £91.40 million (HM Treasury, 2022).

If it invested in decarbonisation, the combined relief would come to £109.25 million, which would more than offset the initial £100 million investment (HM Treasury, 2022).

These allowances have contributed to relatively small tax collections from ring fence corporation tax and supplementary charge over the past six years (see Figure 2). When compared to the company revenues from oil and gas extraction, the tax collections have been minuscule between 2016/17 and 2020/21, and the value of allowances has exceeded tax collections every year in consideration.

Figure 2: Tax collections contrasted with revenues from oil and gas extraction (panel A), and tax collections contrasted with the reliefs (panel B), £ billion

Source: HM Revenue and Customs, 2022; North Sea Transition Authority, 2022; Office for Budget Responsibility, 2022

What about UK commitments to reducing carbon emissions?

These levies are likely to be detrimental to the target of reaching net zero by 2050 (Department for Business, Energy and Industrial Strategy, 2022). This is because the allowances are built to give incentives for investment in continuing extraction of oil and gas instead of renewables (Matikonis, 2022).

The extension of the energy profits levy announced in the Autumn Statement 2022 included an attempt to give incentives to oil and gas producers to invest in decarbonisation. But the allowances still do not seem to extend to investments in renewables, at least based on the limited documentation (HM Treasury, 2022).

The government also introduced an additional tax – the electricity generator levy – on renewable energy producers. This charges 45% on the exceptionally generated receipts that are above the price of £75 per megawatt hour (MWh) and will be effective from 1 January 2023 to 31 March 2028.

Critics of this levy – such as the  Association for Renewable Energy and Clean Technology – note that it is explicitly targeted at cleaner energy but exempts gas-generated electricity. As a result, it will hinder efforts to reach the net-zero target.

What does evidence from academic research tell us about windfall taxes?

The consensus among researchers is broadly against one-off windfall taxes, especially those applied to future profits (see, for example, Bunsgaard and Verton, 2022). This is because they are distortionary and increase investor risks, especially if applied to future profits.

The windfall taxes could create uncertainty in the tax system and give companies incentives to relocate their activities to countries with more stable fiscal regimes.

The most recent windfall taxes introduced in the UK were those that Margaret Thatcher levied on bank deposits in 1981 and those that Tony Blair imposed on the privatised utility companies in 1997.

The latter example was primarily evaluated negatively, with findings pointing to the lack of actual abnormal returns (Antoniou et al, 2000), the negative impact on investors’ confidence (Chennells, 1997) and the subsequent reduction in employment (Tickell, 1998).

This is echoed by the evaluations of windfall taxes on oil extraction in other countries. For example, one study found that the windfall tax imposed on the oil industry after the oil embargo of the Organization of Petroleum Exporting Countries (OPEC) had a negative impact on future extraction in the United States (Nirupama, 2018).

What else do we need to know?

Although there have been studies investigating the effects of various windfall taxes, the structure of each of these taxes differed. This makes any attempt to generalise from previous implementations challenging. Future research needs empirical data to assess how these levies affect investments and subsequent employment.

Further, levies have been hastily introduced with limited consultations, which has resulted in technical deficiencies in mechanisms that have already been highlighted (Matikonis, 2022). Further analysis of the potential flaws – especially in the instruments announced in the Autumn Statement 2022 – is still needed.

More research also needs to be done to guide a more sustainable fiscal regime for energy. Public spending and taxes – the fiscal regime – in this area have historically been seen to lack focus on longer-term objectives (Kemp, 2014). For example, it is considered to be weaker in the UK than in Norway, which also operates in the North Sea (Matikonis, 2022).

Where can I find out more?

Who are experts on this question?

  • Alex Kemp
  • Antony Seely
  • Karl Matikonis
  • Phil Greatrex
Author: Karl Matikonis
Picture by Igors Aleksejevs on iStock

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