The Lex Newsletter: windfall energy profits are widespread but hard to tax

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Dear reader,

Sky-high energy prices are inflicting misery on consumers. They have also pushed up the profits of companies such as BP to decade highs. Tackling the former by taxing the latter has obvious political appeal. Calls for a windfall tax have intensified in the run-up to Britain’s local elections on Thursday.

The government is, rightly, resisting. Arbitrary tax raids have a chilling effect on investment. Companies require higher returns to compensate for the extra risk associated with unpredictable regimes.

In principle, a one-off tax based on past profits should not distort behaviour. In practice, it does. The Labour government’s 1997 £5.2bn windfall tax was based on the premise that utilities had been under-regulated and privatised too cheaply. Even so, some power companies cut back their investments in response.

On Tuesday, there was a hint of a quid pro quo. As Prime Minister Boris Johnson all but ruled out a windfall tax, BP said it was increasing its investment in the UK this decade from its historic range of between 10 and 15 per cent of its capital to between 15 and 20 per cent. “We’re backing Britain,” proclaimed boss Bernard Looney in a press release announcing up to £18bn of investment in the UK’s energy system by the end of 2030.

The threat of a windfall tax remains in the background if energy companies fail to stump up sufficient investment. Chancellor Rishi Sunak recently said “nothing is ever off the table in these things”. Should he choose to ratchet up tax rates, he could point to a precedent. One of his predecessors George Osborne pushed up North Sea taxes in 2011 in response to “unexpected profits on oil prices”, though flagging North Sea output prompted him to cut them again in 2016.

It is easier to justify high tax rates on extractive industries than on other industries. One reason is that the resources are owned by the nation and extracted under licence. Lord John Browne, chief executive of BP for 12 years until 2007, recently said it was “not unreasonable” for the nation to take a bigger portion of the rent for the Treasury if prices stayed high.

Chart showing the declining production of crude oil in the North Sea. Total crude oil (millions of tonnes, annual. tonne = 7.4 barrels), 1990-2020

Just as contentious are the questions raised about the windfall profits of renewable energy companies. The UK, like the EU, the US and other jurisdictions, pays electricity generators the marginal cost of the most expensive producer — usually a gas-powered station — required to meet demand. That means the soaring price of gas is delivering windfall profits for many energy companies, including renewable generators. The European Commission recently gave approval to member states wishing to tax them.

Not all these energy providers are getting a windfall. Among the exceptions are those — largely offshore wind generators — that receive a guaranteed price. If the market price goes above it, they have to pay back the extra amount. That amount is forecast to be £660mn over the 18 months to April 2023, according to the Energy & Climate Intelligence Unit.

That is a positive development, as far as it goes. The contract for difference scheme was introduced only in 2017. Gas prices still exert a huge influence over electricity prices, outstripping the 40 per cent of electricity that it generates. That created plenty of windfalls but it is tough for politicians to pile on taxes on green energy businesses. Just ask Madrid. It backtracked on a levy on Spain’s electricity companies’ “excess profits” last October after the sector said the measure put future investment at risk.

A windfall tax on renewables is not discussed much in the UK. But analysts probed UK-based renewable energy generator Drax about the possibility recently. In response, it said imposing a windfall tax would damage the UK’s reputation.

A backlash would indeed be likely. The need to accelerate the transition towards renewables makes windfall taxes hard to apply — even when energy consumers are suffering and profits are soaring.

Here’s hoping the rest of your week isn’t too taxing.

Vanessa Houlder
Lex writer

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