Windfall Profits: A Lesson from the U.K.

Regardless of your position on windfall profits taxes on oil companies, one thing has been demonstrated again and again. Governments consistently fail to accurately anticipate the consequences. As oil prices have increased, governments have seen tax revenues from oil and gas grow significantly. But they apparently believe they know how to deal with a goose that lays golden eggs: Take some food away from that corpulent goose, but expect it to keep laying golden eggs.

The purpose for imposing windfall profits taxes is generally two-fold. First, a government can tell the citizens that despite their inability to control oil and gas prices, they are doing something by “punishing” the oil companies that benefit from these rising prices. Second, they genuinely see it as a rich source of revenue that they can squeeze without consequence. They think the only real people who will be affected are those who are directly involved with oil and gas companies.

History has shown again and again that this viewpoint is inaccurate. That hasn’t stopped recent attempts in California, with Proposition 87, and current attempts in Wisconsin to again try dipping into this “consequence-free” pot of money. While I favor the direct approach – tax oil and gas on the consumption side – recent attempts have focused on taxing it on the production side, while writing into the legislation provisions to prevent costs from trickling down to consumers. I have previously noted the stunning naivety of this approach, and that these attempts are destined for failure.

It turns out that we now have another example to add to the list in which politicians inaccurately gauged the consequences. The story more or less starts right after Hurricane Katrina. U.K. Chancellor and soon-to-be Prime Minister Gordon Brown detailed what he believed needed to be done to bring down gas prices:

Brown calls for oil price effort

Chancellor Gordon Brown has called for a “concerted effort” by oil-producing countries to bring down prices – but is not offering to cut taxes on petrol.

Ahead of expected fuel duty protests, Mr Brown told the TUC Opec countries to produce more oil and refine more.

Mr Brown called for more worldwide investment in refineries and alternative energies.

So, he told OPEC to produce more oil. I bet they got right on that. The last statement is the most interesting, in light of the move that Brown made just a few months later:

Brown doubles North Sea oil tax

Chancellor Gordon Brown has announced a rise in the tax levied on North Sea oil producers in the wake of record crude prices. Under the measure, the government’s supplementary charge on energy companies will rise to 20% from 10%.

Mr Brown also said there would be no further rises in the North Sea oil tax during this parliament.

Meanwhile, the extra revenue raised would be used to “help consumers most affected by the significant increases in global oil and energy prices” such as pensioner households, the government said.

“Governments levy taxes and we will do what we have to,” said a BP spokesman. “But any extra tax that we pay is money that is no longer available for investment in North Sea oil and gas fields.”

So, Brown called for more investment, and then doubled the surcharge (bringing the total corporate tax rate for oil companies to 50%). I guess he thought he would sit back and watch the revenues come rolling in, and then use those revenues to help consumers affected by higher energy prices. But not only do you discourage investment with these sorts of moves, rising oil prices also increase the costs of everything associated with the oil business. I could have told him that while his strategy might work in the very short term, it would certainly be akin to cutting a research budget: Short term gain, with often longer term consequences.

Brown’s reality checks have started to arrive. In a prescient article written in February 2007, Shadow Chancellor George Osborne got to the crux of the matter:

Gordon Brown is squandering North Sea oil assets

By squeezing the maximum amount of tax revenue from Britain’s oil and gas assets, Gordon Brown is putting further offshore investment at risk, George Osborne has warned.

Accusing the Treasury of failing to understand that the UK Continental Shelf is a mature resource competing for investment in a fiercely competitive global market, he went on: “They don’t recognise that investment in the North Sea cannot be taken for granted when there are potentially more profitable opportunities in West Africa, Mexico or Brazil.

In short, Gordon Brown risks denying future generations the benefits our generation has enjoyed from the North Sea. He’s more interested in cash today than investment tomorrow. The result is that Britain’s North Sea inheritance is in danger of being squandered.”

Last week, the treasury announced that things weren’t working out as forecast:

North Sea Revenues Drying Up

Source: Daily Mail; London (UK)

Publication date: 2007-03-22


The Treasury is nursing a Pounds 5bn shortfall in North Sea oil and gas revenues after a sharp rise in tax rates failed to bring in the targeted result. North Sea revenues for 2006/7 were only Pounds 8bn, against a projected Pounds 13bn. Though North Sea production is declining, the fall cannot be explained by this alone. The UK Offshore Operators Association (UKOOA) says the Treasury did not foresee that a rise in crude oil prices would be followed by a sharp rise in costs as the industry scrambled for drilling rigs, skilled workers and specialist equipment.

Surprise! Thus is the short-sightedness of our political leaders.

Brown has admitted that things didn’t work out as planned, but blamed “factors outside the government’s control”:

‘Brown playing games on oil’

Falling North Sea oil revenues will force the government to borrow more than expected, it emerged today, drawing accusations of “panic” from opposition politicians.

Gordon Brown argued in an interview that borrowing remained on a downward trend but added: “What has changed our forecast is what happened to North Sea revenues.”

Mr Brown said North Sea oil revenues would be £5.5bn lower than expected for 2007/08 but argued that the reduction was due to factors outside the government’s control. “That’s no fault of the government. It’s lower production from the North Sea. We have to take that into account,” Mr Brown told the BBC’s Today programme.

No fault of the government? Again, read George Osbourne’s words above. Investment in the North Sea is affected by the tax rates. You have taken money away that could have gone into new investments and diverted it. So, even though North Sea production is in decline, these policies will accelerate that decline by discouraging new investments.

As I said, I support higher gas taxes. That is not my issue at all. My issue is that these politicians have an incredibly naive view and believe they can increase these taxes with no fallout on anyone but the oil companies. Time and time again they see this as a quick fix to budgetary issues, while pandering to a constituency outraged at higher energy prices. It’s just that it never works out they way they thought it would. But I’m sure that won’t stop them from trying again.

10 thoughts on “Windfall Profits: A Lesson from the U.K.”

  1. From an economic standpoint, a tax placed anywhere between “well and wheels” will serve to increase final consumer costs, reduce demand, and therefore consumption.

    I agree that a tax close to wheels has many strengths … but I guess I’m not a purist, because within some range, I’ll accept less equitable arrangements.

    The ultimate goal, for peak oil, global warming, or simple frugality, is to reduce consumption … yes?

    Then guess what, falling North Sea production accomplishes that. The oil is still there. It is in reserve, for new and future investment. But we have reduced our consumption (at least from that source).

    I guess that’s my challenge to you Robert … if peak oil is near, explain to me why under-investment and falling production _now_ are not good things.

  2. From an economic standpoint, a tax placed anywhere between “well and wheels” will serve to increase final consumer costs, reduce demand, and therefore consumption.

    Which is why I never endorsed the “No” vote on Prop 87. I thought it was extremely inefficient. I thought that promises were being made that couldn’t possibly be kept. Oil companies were the subject of a pretty nasty smear campaign by Vinod Khosla. But, would it have reduced demand? Yeah, probably. Not nearly as efficient as an additional $o.o5/gal gas tax.

    I guess that’s my challenge to you Robert … if peak oil is near, explain to me why under-investment and falling production _now_ are not good things.

    And of course therein lies the dilemma. It just annoys me that these political leaders are so incredibly naïve about all this. I also hate this sort of pandering.

    The one thing about falling production right now, though, is that if peak oil is on top of us, this will exacerbate the problem. We won’t be able to just turn on the taps; some of these investments will take a while to start paying dividends. It’s a matter of timing. You don’t want to overproduce now and suffer the consequences later, but then again you don’t want to hit peak oil after falling way behind on infrastructure investments.

    Cheers, RR

  3. To understand why windfall taxes on the producers are bad idea, you just need to look at the reasons why Politicians love them. As odograph points out….

    From an economic standpoint, a tax placed anywhere between “well and wheels” will serve to increase final consumer costs, reduce demand, and therefore consumption.

    So why then are Politician’s always willing to impose windfall taxes as apposed to other consumption taxes? Because they can fool consumers into thinking that it is only the evil producers that have to pay the price.

    Because of the deceitful nature of these taxes, I take that exact opposite tact as odograph.

    To my mind, windfall taxes are worse then having no tax at all even if they reduced oil consumption. The elitist idea that it is alright to peruse noble ends even if you have to deceive the common people does not sit very well with me.

    The fundamental problem facing the oil consumers is the need to change the way that they live. By trying to deal with this fact with taxes designed to obscure their real cost, the elites are fostering the illusion that this problem is the result of a few evil bad guys.

    By fostering the idea that this is a problem with “them” instead of “us” the elites are empowering demagogues who come down the road. If these demagogues are in mold of the fascist and communists of old, the damage done will far out way any modest befits that these taxes bring.

  4. You know Ape Man, I can see what you’re saying, and I don’t strongly disagree.

    For what it’s worth though, I see it more as a need to lie to ourselves. I don’t think we actually need elites to help us with that.

    We see it in the US when we (a) tell pollsters that we want higher MPG for our cars, and then (b) go down to buy an SUV or a hot rod.

  5. Oh, I did not mean to imply that all the blame should be place on the Elites. That would be demagogy.:)

    If people loved the truth, deceit would have no place in politics. But just because people don’t like the truth is not a good reason to base policy around deceit. It just stores up problems for every one involved.

  6. odograph, You said,

    “Then guess what, falling North Sea production accomplishes that. The oil is still there. It is in reserve, for new and future investment.”

    That is not really correct, and the reason is the infrastructure needed to produce the smaller fields is not permanently in place.

    The smaller fields are financially viable as long as there is existing infrastructure to receive / process / transport their output. Fields below a certain size aren’t financially viable if they have to pay for new production facilities.

    As the larger fields deplete the smaller fields can be brought on stream and this production can keep the existing facilites running at capacity.

    If the smaller fields are not developed now the existing facilities will be decommisioned and removed when the existing fields deplete below the point of economic viability.

    Because of the the smaller fields will likely never be produced if they are not produced now.


  7. It’s a bit silly to claim ‘Mr. Brown’s reality checks have started to arrive’. North Sea production is not falling because higher taxes discouraged investment — to the contrary 2006 North Sea investment was the highest in eight years. The problem is clearly geological, exacerbated by low investment after oil prices crashed in the late ’90s. The effects of Mr. Brown’s tax will show up one day, of course, just not yet.

    I agree windfall profit taxes are simply political pandering. Severance taxes should be on a sliding scale — that’s one thing CA’s Prop 87 got right. Oil production is a partnership between the citizenry, who own the oil, and industry which provides the labor and capital to extract it. Both partners should profit together when oil prices rise and suffer when they fall. A sliding-scale tax eliminates the need for political pandering. It also eliminates a source of uncertainty for oil companies — giving them a more predictable environment in which to make long term decisions and eliminating the need for them to ‘participate’ excessively in the political process.


  8. Over in a thread at Gristmill:

    Stephanie Paige Ogburn posted a link to a survey:

    it is scary in its details. that poll confirms my worst fears. people foolishly believe they can legislate “car companies” into making more efficient vehicles, as they go on buying whatever they want.

    maybe stuff like that is why I don’t worry too much about “imperfect” energy taxes.

  9. North Sea production is not falling because higher taxes discouraged investment — to the contrary 2006 North Sea investment was the highest in eight years.

    Do you have a reference for that? I do know for a fact that some marginal production was shut in as the new taxes pushed it into the “no longer profitable” category. So while geology is a big factor, these taxes have increased the rate of decline.

    Cheers, RR

  10. “UK oil and gas capital investment was £5.6 billion last year, its highest since 1998, while the year was also successful for exploration.”

    Note that some of this increase was just cost increases as oppposed to additional activity. Also note 2007 investment is expected to decline (the tax may play a role here).


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