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Radical reform of the North Sea fiscal regime is essential

    The collapse in oil prices that we have seen since the latter half of last year has helped to push down inflation across developed economies; in the UK for example, CPI has fallen to an historic low of 0.3%. However, the key negative consequence of the fall in the oil price to near $50 a barrel is the effect it is having on the North Sea oil and gas sector. The sector provides 380,000 jobs and according to Sir Ian Wood, if there is no action taken then up to 100,000 jobs could be lost over the next couple of years. This would come alongside further falls in revenue and production. In his Budget today, it is therefore essential that the Chancellor takes action to help resolve these serious problems facing the North Sea as we suggested in our recent Economic Bulletin.

    The fiscal regime for the exploration and production of oil and gas is in dire need of reform. Tax revenues have collapsed in recent years despite much higher tax rates and oil output has continued to fall. Meanwhile, Brent crude oil prices have fallen by about half over the last nine months. According to DECC, in 2012-2013 tax revenues from UK oil and gas production dropped by around 45% to £6.1 billion and then fell again in 2013-14 by around 25% to £4.7 billion. In its Economic and Fiscal Outlook published in December, the OBR forecasts that North Sea tax revenues will have fallen by about 75% between 2011/12 and 2014/15 to reach £2.8 billion.

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    North Sea production has fallen by an average of 7.8% each year since 1999 and even if production rises by 20% over the next five years as Oil & Gas UK, the industry’s main UK trade association, suggested last year, that would only take production back to the levels last seen in 2011/12. Moreover, as the graph below from the OBR’s Fiscal Sustainability Report published last year shows, official forecasts of North Sea production have been systematically far too optimistic.

    The tax regime that applies in the exploration and production of the UK’s oil and gas has three elements: the Ring Fence Corporation Tax (RFCT), the Supplementary Charge (SC) and the Petroleum Revenue Tax (PRT). Until 2002/03 there was also revenue from royalties. The RFCT is the standard corporation tax that applies to all UK companies with the addition of a ‘ring fence’ and is currently 30%.

    The RFCT offers the opportunity of a tax free allowance in the first year for all capital expenditure and is designed in such a way to prevent the reduction of taxable profits from other business activities. In 2011 the government introduced a brown field allowance for incremental projects in existing fields and a £3 billion field allowance to support investment in the West of Shetland. Also, the Ring Fence Expenditure Supplement was introduced for companies that do not yet have sufficient taxable income for the RFCT.

    In March 2011 the rate of the Supplementary Charge (an addition to the corporation tax) increased from 20% to 32%. In December 2014, the Government cut this rate from 32% to 30%. The PRT is a field-based tax that charges the profits from the production of oil and gas which were sanctioned before 16 March 1993 and is currently set at 50% after a series of allowances. As the EIA explains, the marginal tax rate for fields that are subject to the PRT increased to 81% of their profits from 75% and fields that are not subject to the PRT have had to pay a 62% tax which is up from 50%. Although, the recent small cut will have slightly improved this situation.

    It is clear that the higher tax rates have made the UK oil fields less competitive especially within the context of high operating and decommissioning costs. According to an Oil and Gas Activity Survey, the average unit operating costs have risen to £17 per barrel of oil equivalent, while the number of fields with an operating cost greater than £30 per barrel of oil equivalent has doubled between 2013 and 2014. This seems likely to have deteriorated in recent months.

    The 2011 tax increase was considered a short term deficit reduction measure although revenue has clearly fallen. As the OBR outlined in its Fiscal Sustainability Report, the 50% decline in production over the last six years has obviously contributed to the fall in tax revenue. Another significant factor has also been the 150% rise in capital expenditure over the same period. As a capital expenditure is fully tax-deductible, its large rise has helped to reduce the effective tax rate despite the big rise in the Supplementary Charge.

    Whilst in the Autumn Statement, the Government announced a small cut in the Supplementary Charge from 32% to 30% it is important that it uses the Budget to implement much more far-reaching reforms of the North Sea fiscal regime. A much bigger cut in the Supplementary Charge should be carried out and investment allowances should be simplified, streamlined and significantly expanded. Domestic production, thousands of jobs and Britain’s energy security all depend on the Government taking action in the Budget today.

    Angeliki Terpou is an energy economist and the author of ‘Britain’s deteriorating energy security and why we must frack’.

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