The UK’s North Sea has changed – so too must the way we tax it

Last April I wrote in this paper about how the Government’s recently published British Energy Security Strategy would help restore investor confidence and breathe new life into the North Sea. Despite all the tumult we have seen since, this remains the right strategy for the country.

But in the months since, things have taken a turn. The introduction of two new windfall taxes – or Energy Profits Levies – have sent investor confidence to an all-time low, putting at risk the vital work government and industry must do to bolster energy security and deliver the net zero transition.

A decade ago, the impact would not have been so significant. Those who invested in the North Sea were mainly major international energy groups with the balance sheets to absorb temporary increases in taxation across their global portfolios.

Today, the bulk of both production and investment in the UK’s North Sea does not come from the majors, but from independent energy companies that are focused on unlocking the vital energy sources that the North Sea still offers, many of which are financed from the City of London.

While majors have moved out of the North Sea, the independents have moved in. In the last six years, these companies have invested more than $50 billion in the basin – more than double that of the larger companies who used to dominate. Collectively, they now produce more than 50% of the UK’s oil and gas needs – a number that will grow in the years ahead.

Yet, it is on the shoulders of these independent companies that the impact of these new windfall taxes falls disproportionately. Unlike the majors, these companies don’t have the same level of balance sheet power and rely on external sources of funding that come with more strings attached.

Like any lender, banks require collateral to provide finance. For independents, their borrowing capacity is determined by the value of their reserves, much like a mortgage on the value of a house. Higher taxes erode the value of these reserves, restricting their ability to access investment capital and continue to invest in new projects.

Lenders also require them to sell production forward to protect future revenues. What they produce today is not sold at current prices, but at ‘realised’ prices agreed two or even three years ago, when prices were significantly lower.

Energy retailers that bought this gas forward have benefited from this, lowering the cost of supply to consumers.

Clearly the sector – including independent companies – must play its role in ensuring the country can balance the books. To avoid this coming at the expense of long-term energy security goals, there are two simple steps that I believe the Government can take to create a tax environment that still unlocks major investment.

First, the new windfall tax should include a price floor – as is the case for power producers. If commodity prices remain high (as it forecasts they will) then the higher levels of tax should only apply to that proportion of revenue that is higher than historical averages. If they fall back to historic averages, it falls away.

Second, as a windfall tax, the EPL should target only actual profits by factoring in realised prices – in other words, the revenue that the companies actually earn when they sell their energy ahead of time, rather than at current high prices that reflect only a fraction of what they sell. Profit derived from production sold at or below the level of the floor price should be exempt.

Implementing these two simple changes will ensure independents can access finance, providing them with the capital to invest now for the future – not only for new sources of gas and oil, but also, importantly, for repurposing facilities for the energy transition.

The Government was right to implement an investment allowance alongside the EPL – and its recently announced new exploration licencing round was welcomed by the sector. This will help maintain the domestic resource that is essential to the UK’s energy security, while drawing on the sector’s skills and know-how to develop new technologies and scale up production.

Both the Prime Minister and the Chancellor spent their previous careers in finance. They reacted quickly and decisively to restore confidence in the UK’s financial markets in the autumn.

They must now react just as quickly to ensure the UK’s laudable aim of energy independence by 2040 does not fall at the first hurdle.