14 September 2022 Economics & Growth | Europe | Monetary Policy & Inflation

The Energy Crisis: What Should Windfall Taxes Look Like?

Summary

A new IMF paper offers guidance on windfall taxes given the European energy crisis and soaring energy firm profits.
It argues for permanent, transparent taxes targeted at windfall profits to reduce investor uncertainty.
Pessimistically, it acknowledges politics will play an outsized role in deciding how to tax energy firms.

Introduction

Large oil and gas companies have achieved unprecedented returns in recent months. Firms such as ExxonMobil and Chevron saw profits more than treble (Chart 1).

Amid skyrocketing bills and falling living standards for households, calls for special taxes targeting these windfall profits are growing. A new IMF paper offers investors insight into the form windfall taxes may take and how they will impact markets.

Who Exactly Is Making Money?

Distinguishing between upstream stages such as extraction and mid- and down-stream activities such as refining and energy generation is essential to targeting windfall taxes.

The paper notes most of the excess profit in late 2021 and early 2022 fell to companies engaged in extraction, rather than refining or power generation. In Q2 of 2022, refining and downstream companies saw growth in profits.

Principles for Taxing Windfall Profits

However, the paper proposes common principles for designing windfall taxes that apply to every stage of the production process.

Firstly, governments must consider the distorting effect of tax on production decisions, which requires understanding ‘economic rent’. This is the return on investment above the minimum threshold for the investment to be made.

Rent is a common concept in sectors involved in resource extraction due to limited natural resources, the unpredictable quality of deposits, and cyclical factors such as sudden, large increases in demand. These factors make it harder for supply to adjust to demand, leading to dramatic and unexpected increases in price. As a result, when prices increase, firms gain excess profits. The paper argues that so long as windfall taxes target only these excess profits, they can avoid disincentivising investment.

Another factor is predictability. The IMF recommends transparent and consistent taxes on windfall profits. Introducing temporary taxes may be politically expedient, but it can also increase investor uncertainty. When taxes are unpredictable, investors need a greater incentive to put money into a project, reducing overall investment in energy.

Finally, governments must consider the administrative difficulty of raising taxes. While some taxes can target excess profits precisely, developing countries may lack the state capacity to implement them. Nations in this position will have to strike a balance between avoiding distortionary taxes and administrative complexity.

What Types of Tax Are Possible for Upstream Extraction?

Cumulative-Rate-of-Return-Based Cashflow Tax

This tax is designed to kick in only once a project starts generating excess profits. It works by uplifting the negative cashflow by the threshold rate of return, meaning the project will only generate net positive cashflow and start to be taxed after exceeding the threshold rate.

Project-Level Tax With Uplift on Capital Expenditure

This method works like the cashflow tax. A percentage uplift is applied to capital expenditure (which is deducted from profit) so the tax only applies to revenue once it exceeds the threshold rate of investment.

R-Factor-Based Progressive Profit Oil Sharing

Common in production-sharing contracts, this approach is based on the R-factor: the ratio between cumulative net revenue and investment. Once cumulative net revenue is greater than investment (the R-factor is greater than one), a progressive tax structure is applied that accounts for the threshold rate of return.

Supplementary Tax on Corporate Profits

The tax is implemented when a certain profit threshold is met. It is less targeted than other methods as corporate profits may come from other projects, unrelated to those generating economic rent.

Variable Royalty Rate Linked to Commodity Prices

The government takes a share of revenue that varies with commodity prices, so that large increases in demand lead to higher taxation. The drawback is this increases the variable cost of production, leading to lower supply.

How Effective Are These Taxes?

The paper says choosing the appropriate tax instrument depends on its ability to target rents versus the administrative complexity of implementation. Table 1 summarises the pros and cons of each regime.

Table 2 shows a selection of tax regimes by country. The most common approach is the tax-royalty approach.

The IMF assesses the tax regimes above by working out the average effective tax rate (AETR) on barrels of oil. Taxes that target profit have a much smaller effect on the breakeven price – the price of a barrel of oil required to justify production.

For example, the AETR for Norway is significantly higher than in offshore US projects, around 85% and 40%, respectively. The breakeven price is just $5 per barrel higher for Norway (Chart 2). The government receives significantly higher revenue with only a small difference in the breakeven price.

The authors also note that the recently introduced Energy Profit Levy aligns the UK with the international standard for AETRs on energy production.

Advice for Taxing Refineries and Electricity Generators

While similar principles of taxation apply to taxing mid- and down-stream producers, the picture here is more complex.

Firstly, excess profits are mostly captured at the upstream stage of production. This means that taxes on mid- and down-stream producers will mostly be passed onto consumers.

In Q2, however, the spread between pre-tax retail prices and crude oil prices widened (Chart 3). This indicates mid- and down-stream producers have been capturing a share of the excess profits from price rises.

The paper suggests this is due to a ‘confluence of events,’ such as sanctions on Russian petroleum products, reduced petroleum product export quotas in China and reduced US refinery capacity. A study by the US Energy Information Administration found refinery profits in all US regions are ‘above or near 10-year highs.’ In the current case, then, excess profits should be taxed according to the same principles outlined above.

Finally, the energy transition further complicates the picture. As the paper notes, electricity producers have also benefited from economic rents. In Europe, where higher gas prices have driven up electricity prices, producers with fixed cost structures have seen large increases in their profit. This group includes renewable and nuclear electricity producers as well as fossil-fuel based producers with contracts that guarantee their purchase price for natural gas and coal.

The paper argues that any tax targeting economic rents at this stage must distinguish between renewable and non-renewable technology. Any negative signal to producers and investors may jeopardise the energy transition.

Bottom Line

The paper concludes that, ultimately, political pressures will likely decide which approach governments take. It carefully lays out the economic reasons why governments should tax windfall profits consistently and transparently. But it also acknowledges that governments have other priorities. This is partly why they advocate for permanent methods for taxing economic rents.

We have seen this in debates over the energy price cap in the UK. Part of the pressure for windfall taxes comes from the unfairness of households struggling while big business sees booming profits. The solutions politicians propose are designed to meet this demand for the appearance of justice, not economic efficiency. As the Economist noted recently, Labour’s call to freeze the energy price cap is a ‘silly policy’ but ‘smart politics.’