America is right, the UK’s North Sea tax regime needs reforming

The Americans claim that North Sea tax system is inhibiting investment. Nick Bramhall, CC BY-SA

The UK North Sea is attracting attention once again after being overshadowed by the shale debate for quite some time. Most recently this has been thanks to the UK government’s announcement this week of a formal consultation to review the offshore petroleum tax regime.

This followed comments last week by the US Energy Information Administration (EIA) about the UK petroleum fiscal regime making the North Sea unattractive for exploration and production. The EIA said the current fiscal regime has contributed to a sharp decline in oil production and has made the country less competitive. This argument is echoed by the industry association for upstream companies, Oil & Gas UK, which states that investors are increasingly looking to invest elsewhere.

What investors think…

From an investment perspective, a combination of commercial and non-commercial factors come into play when assessing the competitiveness of an oil and gas province. This would include things like geology, the oil price and drilling costs, all of which are beyond the host government’s control, so it is hard to single out the tax regime and directly link it to investment figures. Nonetheless, no one could argue that the fiscal situation will play a big part in companies deciding where and how much to invest.

The oil and gas industry is the most highly taxed business in the UK. Fields developed since March 1993 are taxed at 62%, which comprises a corporation tax of 30% (compared to 21% for all other industries) and a supplementary charge of 32%. Fields developed before 1993 are also subject to a petroleum revenue tax (PRT) at 50%, which brings their overall marginal tax rate to 81%. The reason for rates that are much higher than other sectors is because of the special features of the industry, mainly the potential for extraordinary profits.

This disparity between the taxes on petroleum and on other sectors is not unusual. Across the OECD, all sectors in the economy with the exception of oil and gas are subject to an average income tax rate of 24%, down from 33% in 2000. In the oil and gas sector, the average government take –- meaning the share of revenues that accrues to the government over the life of a project – varies between 65% and 85%. In this regard, the UK is not much different.

And while the overall government take is important, the impact of tax instruments on cost recovery is also relevant. The UK petroleum fiscal regime has has the most generous depreciation system in the world, for example. Instead of depreciating investment over a number of years in the usual accounting style, the UK permits a 100% write-off in the first year. This has major implications for the length of time it takes for companies to get their investments back, which boosts the attractiveness of the UK regime. Not surprisingly perhaps, other governments are not comfortable with the policy.

Rather more Mexican than Angolan

Having said that, the UK’s high rate of 81% is unsustainable. The condition of the UK continental shelf must be kept in perspective. Such a high level of government take is not justified in jurisdictions where development costs are high and the petroleum potential is only modest, which is the case in the UK North Sea.

While more fields have been discovered since the 1990s, they have been progressively smaller. Their average discovery size is 25-30m barrels of oil equivalent (mboe) compared to the giant Forties and Brent fields discovered in the 1970s, where the size of each originally exceeded 2400mboe.

The newer fields also have a shorter lifetime and tend to be technically more difficult to access. So the UK cannot put itself in the same league as countries like Angola, where the higher resource potential and lower cost of development can justify a government take that is above 80% in many cases. In contrast, in the US Gulf of Mexico, a mature but still active province, the government take can be below 50%.

Other problems with the UK system

A second issue for the UK petroleum tax regime is that since it was established in 1975, it has often been reviewed and amended. No other sector in the UK economy has been subject to such fiscal instability. Again and again, UK governments have succumbed to the temptation of changing tax rates and structures, mainly in response to oil price changes. Yet the oil price moves in unpredictable ways and so do costs, which are correlated with price movements.

The continuous increase in the headline tax rate since 2002 may have captured higher tax revenues in the short term, but it has almost certainly reduced the attractiveness of the province to investors as well. Norway is often cited as a contrasting example, where the government take of 78% is seen as acceptable in the context of a fiscal regime which has shown impressive resilience to changes in oil prices. Norway also still has many large fields producing or awaiting development.

The other problem with the UK fiscal regime is that it has become too complex, creating a higher administrative burden for the companies involved. In an attempt to achieve the difficult balance between preserving the high tax take on profitable fields and allowing a lower take on certain new and smaller fields, for example, the UK government has introduced targeted incentives to aid the development of marginal fields and encourage late-life field investment. The result is a wide spectrum of effective tax rates varying between 30% and 81%. An additional problem here is that targeting can never be perfect. Some investments will inevitably benefit from tax incentives even though they do not require them.

The perception of the North Sea is often one of declining production, fields having passed their prime, rising costs, and looming decommissioning. It does not have to be this way. The UK continental shelf has much remaining potential (11 and 21 billion boe), but this will only be realised if the UK continental shelf stays competitive as possible for as long as possible. Doing this means addressing the three problems above: high tax take, complexity and instability. Let’s hope the forthcoming UK consultation reaches the same conclusion.