Navigating the Future of UK Oil and Gas Taxation

The United Kingdom's oil and gas industry has historically been a cornerstone of the nation's economy, contributing significantly to public finances and employment, particularly in regions like North-East Scotland. As the UK embarks on a crucial energy transition, the government is keen to provide a stable and predictable fiscal environment for the sector. This involves a forward-looking approach to taxation, acknowledging the need to balance the benefits derived from the nation's natural resources with the imperative to encourage investment, particularly in the evolving energy landscape. A key element of this strategy is the proposed introduction of a new Oil and Gas Price Mechanism, designed to respond to future price shocks and ensure the UK benefits from periods of unusually high prices, while safeguarding investment during more stable times.

The Evolving Fiscal Landscape

The UK's fiscal regime for oil and gas has seen several adjustments over the years. Currently, it comprises three permanent elements: Ring Fence Corporation Tax (RFCT), Supplementary Charge (SC), and Petroleum Revenue Tax (PRT), alongside the temporary Energy Profits Levy (EPL). The EPL, introduced in response to extraordinary profits driven by global events, is set to expire on 31 March 2030, or earlier if the Energy Security Investment Mechanism (ESIM) is triggered. Recognising the importance of long-term certainty for investors, the government is committed to replacing the EPL with a new, permanent mechanism that will provide clarity on how the fiscal regime will react to future oil and gas price fluctuations.

The government's core principle is that during periods of unusually high oil and gas prices, the sector should make an additional contribution to public finances. This consultation seeks views on how to design a new mechanism that achieves this while remaining predictable, sustainable, and minimising distortions to investment decisions when prices are not unusually high. This approach aims to support continued investment in domestic oil and gas production throughout the energy transition, ensuring jobs are protected and the UK capitalises on new economic opportunities.

Key Policy Objectives for the New Mechanism

The government has outlined five principal objectives to guide the design of the new Oil and Gas Price Mechanism:

• Deliver a fair return on the UK’s resources at times of unusually high prices: Ensuring the UK economy benefits appropriately when natural resource exploitation yields exceptionally high profits.
• Be predictable and provide certainty: Establishing clear rules and thresholds in advance to allow industry and investors to plan with confidence.
• Minimise distortions on investment decisions: Designing the mechanism so it does not unduly influence investment choices during periods of normal price levels.
• Minimise administrative burdens for taxpayers and HMRC: Aiming for a simple and efficient mechanism to administer, leveraging existing systems where possible.
• Recognise the difference between oil and gas markets: Acknowledging the evolving dynamics and potential divergences in price movements between oil and gas.

These objectives are crucial for fostering a stable investment climate that supports both the Exchequer's needs and the industry's capacity for innovation and growth.

Understanding the Policy Options: RBM vs. PBM

The government is consulting on two primary policy options for the new mechanism:

1. Revenue-Based Model (RBM)

The RBM would target excess revenue generated when oil and gas prices exceed pre-defined threshold prices. For instance, if the threshold for oil is $2 per barrel and a company sells a barrel for $3, the $1 excess revenue would be subject to the mechanism. This model would consider realised prices, accounting for hedging and other financial instruments used by companies. The government's initial preference leans towards the RBM due to its perceived ability to more effectively target gains from high prices, minimise investment distortions, and more easily distinguish between oil and gas markets.

Key Features of RBM:

• Targets revenue above specified thresholds.
• Utilises realised prices, including gains/losses from hedging.
• Applies to each transaction or grouped transaction.
• No deductions for costs apply to the targeted revenue.
• Tax point is the first point of sale following extraction.

2. Profit-Based Model (PBM)

The PBM would target a proportion of profits deemed to arise from unusually high prices. This proportion would be calculated by comparing an 'average market price' against the defined thresholds. The PBM would apply to the element of profit that corresponds to the extent to which the average market price exceeds the threshold. This model requires careful consideration of how to attribute profits to oil and gas separately, potentially using proxies such as revenue shares or production volumes.

Key Features of PBM:

• Targets a proportion of profits linked to price deviations above thresholds.
• Uses 'average market price' over an accounting period.
• Profit base is adjusted ring fence profit, excluding certain costs.
• May use proxies to distinguish between oil and gas profits.

A comparative analysis highlights that while both models aim to meet the government's objectives, the RBM is seen as more effective in targeting excess gains and distinguishing between oil and gas markets. However, the government is seeking comprehensive feedback on the strengths and weaknesses of each approach.

Defining Unusually High Prices and Setting Thresholds

A critical aspect of the new mechanism is the definition of 'unusually high prices' and the establishment of corresponding thresholds. The government will consider a range of factors, including:

• Historical Price Data: Examining past price cycles to understand long-term trends and investment decisions made historically. A 'look back' period will be crucial here.
• Oil and Gas Price Forecasts: Incorporating short- and long-term price assumptions used by experts and industry stakeholders. The focus will be on 'medium' or 'central' price scenarios, with consideration for 'high' scenarios.
• Costs of Operating and Investing: Recognising the UKCS as a mature basin, the costs associated with production and investment will be a key consideration. This includes analysing full-cycle average costs per barrel of oil equivalent (BOE) or per therm.

The government is considering setting two distinct thresholds: one for oil and one for gas, to reflect the differences in their respective markets. For oil, the benchmark will likely be Brent Crude prices in US dollars per barrel, while for gas, it will be NBP Day-Ahead prices in pence per therm. The thresholds will be set above average long-term historical prices, current central price assumptions, and the costs associated with operating and investing in the UK/UKCS to ensure they capture excess gains without deterring necessary investment.

Future-Proofing the Thresholds

To maintain predictability and certainty over the long term, the government intends to implement a mechanism for adjusting the thresholds. The primary proposal is to use a UK GDP deflator for annual adjustments, ensuring that the real value of the thresholds remains consistent. This approach aims to provide investors with confidence in the fiscal regime across various price scenarios. The government is seeking stakeholder views on the appropriateness of this adjustment mechanism and potential challenges, particularly concerning the interaction between dollar-denominated oil thresholds and sterling-based economic deflators.

The Role of Oil and Gas in the Energy Transition

While the UK actively pursues its energy transition, the role of domestic oil and gas production remains a subject of discussion. Companies like Equinor view oil and gas as essential components in powering the global economy for years to come, even within Paris-aligned trajectories. The transition itself presents significant investment opportunities in areas such as energy efficiency, renewable capacity expansion, and infrastructure modernisation. Companies are adapting their strategies, with some European majors diverting capital towards other low-carbon opportunities like bioenergy, and mining majors focusing on core commodities and low-risk strategies. Oil and gas companies are increasingly applying stricter capital allocation criteria for hydrocarbon investments, prioritising projects with lower emissions intensity.

Mergers and acquisitions (M&A) and innovative business models are also being explored to finance the energy transition and unlock value. Partial spin-offs, asset sales, and vertical integration are among the strategies being employed. The ability to align project financing with stakeholder appetites, such as through offtake agreements for original equipment manufacturers, is also a key consideration. Ultimately, the UK's journey towards a sustainable energy future will require a dynamic and adaptive approach, balancing established industries with the development of new, low-carbon technologies.

Frequently Asked Questions

What is the main objective of the new Oil and Gas Price Mechanism?

The primary objective is to ensure that the UK benefits from additional revenues during periods of unusually high oil and gas prices, while providing certainty and minimising distortions to investment decisions for the industry.

What are the two main policy options being considered?

The two options are a Revenue-Based Model (RBM), which targets excess revenue, and a Profit-Based Model (PBM), which targets a proportion of profits deemed to arise from high prices.

How will 'unusually high prices' be defined?

This will be determined by setting thresholds for oil and gas prices, informed by historical data, future forecasts, and the costs of operating in the UKCS. Thresholds are expected to be set for both oil (likely in USD/barrel) and gas (likely in p/therm).

Will the new mechanism affect investments made during normal price conditions?

The government aims to minimise distortions on investment decisions during normal price periods. The mechanism is designed to apply only to gains derived from unusually high prices, not to all profits.

How will the thresholds be adjusted over time?

The government is considering using a UK GDP deflator for annual adjustments to ensure the thresholds maintain their real value over the long term, providing ongoing predictability.

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