Why does the UK windfall tax sound like a bad idea?

The recently announced windfall tax doesn't seem like a great idea. On the one hand, it seems that the government wanted to be seen as doing something in the wake of a cost of living crisis hitting the country. To do so, it seems the government chose the easy way out and left itself setting either a dangerous precedent or perhaps inviting a bigger energy crisis in the future.

Let's back up a bit. The cost of living crisis has been induced, as far as we can tell, due to three things:
  • Interruptions to Supply Chain, largely caused by Covid disruptions, especially in China
  • Large scale quantitative easing in the last 2 years leaving the economy flush with cash and the subsequent reopening in play now
  • The war in Ukraine which has upset the energy ecosystem in the world

The UK government can do nothing about Supply Chains, and has already contributed their bit with quantitative easing over the past 2 years, which can't be easily undone (without risking an immediate recession). One of the biggest derivatives of the Ukraine war has been energy prices shooting up. This has directly resulted in significant increases in utility bills (mine have gone up by 100% over the past few months). It is this last factor that the Chancellor is looking to offset.

However, the windfall taxes are odd because they are targeted at a particular sector and are arbitrary in the absence of a proper taxation policy. Let's look at these 2 factors in detail.

Why Non-Renewable Energy Sector Specifically?

To pay for the cost of living increase, the Chancellor is looking to specifically attack the Non-Renewable Energy sector for taxation. Why the Non-Renewable Energy sector alone? There seems to be a bunch of different reasons being provided depending on who you ask

  • They are the ones causing the cost of living to go up
  • They are earning a "windfall" and hence should be taxed on such windfalls
  • Since fossil fuels are causing environmental damage, they should be taxed
  • Non-Renewable Energy companies haven't paid their fair share so far, so let's tax them directly now
  • Non-Renewable Energy companies don't succeed without support of government and aren't independent economic actors, and hence they shouldn't be treated like other private companies

The "cause and effect" argument

Non-Renewable Energy sector isn't the one causing the cost of living to go up. It is the energy policies of the combined European Society that has contributed to where we are today. Starting from shutting down nuclear plants, to preferring to buy energy from dictatorial governments to discouraging investments in energy companies as well as drilling in their own backyards, the western world has largely created a situation where they were dependent on energy from Russia and when that has gone belly up in the last few months, the natural reaction has been a stark increase in energy prices. Non-Renewable Energy sector didn't cause this crisis - for most parts they are reactors to what the governments and policymakers have been pushing for. It is not as if Non-Renewable Energy companies got together and orchestrated an increase in energy prices, or they orchestrated the war in Ukraine, or supported any of the above policies I am talking about. So, this argument seems weak at the outset.

The "windfall" argument

Let's take the "windfall" argument. Here, we are specifically saying these companies are earning for something they didn't specifically earn, i.e. their additional profits are a windfall. At some level, it makes sense that these companies benefited from an event not of their creation. So, perhaps taxing them is OK. However, here we are setting ourselves a dangerous precedent.

In the past 2 years, many companies have benefitted from Covid pandemic without necessarily doing anything different than what they were doing before - i.e. a windfall. Think of food delivery companies, video conferencing companies, e-commerce companies etc. Similarly after the war in Ukraine, some sectors like Aerospace or Defence companies are going to enjoy a windfall due to increased spending from governments on defence budgets. Should they be windfall taxed too?

If we were to say windfalls should be taxed, then we are setting ourselves an argument that all windfalls should be taxed, or none at all. Selectively taxing Non-Renewable Energy companies now seems neither here nor there.

The "environment policy" argument

I get that fossil fuels are bad and we want an energy transition. However, that is going to be achieved by dampening demand, not by extracting profits from Non-Renewable Energy companies. Remember that an unprofitable energy company, i.e. one that doesn't pay windfall taxes, does as much damage to the environment as a profitable one and hence if the true motivation is to encourage energy transition, then taxing profit of energy companies is an idea inferior to taxing demand.

Let's take an example. Company A extracts 1M barrels of crude per day at cost of $50 and sells for $100. They got to pay $12.5M to the government in windfall tax per day. Company B, say an inefficient fracking extraction operation extracts 10M barrels of crude per day at cost of $95 and sells it at $100. They will also pay only $12.5M to the government in windfall tax per day. However company B is generating (a) far worse economic value and (b) far worse environmental outcome. If they both were being taxed through other methods of demand based taxation, say carbon taxes for instance, company A would pay a lot less carbon tax, as the case should absolutely be.

This kind of example isn't as hypothetical as one might think. Oil drilling costs varies wildly on where you are drilling and what methods you use. The cost of production could very well be as stark as in the examples above.

There are so many better ways to structure the transition that is not as absurd as a windfall tax. Here are some examples:

1. Tax demand (add 10p per litre to fuel costs) and use that as a renewables-investment fund.

2. Ask all Non-Renewable Energy companies to take a percentage of their revenue (not profits) and invest it in renewables in a mandatory manner and increase the percentage year on year for the next 15 years. This way the shareholders of these Non-Renewable Energy companies get to participate in the transition.

The tax arbitrage argument

Non-Renewable Energy companies are known for not paying taxes by claiming for various deductions when issuing their corporate tax filing in the UK. This is hardly new and hardly restricted to Non-Renewable Energy companies. Any corporate finance team worth their salt is going to go through every single opportunity they have for reducing their tax bill.

There are two kinds of reasons for tax generation. One is pure funding. This should be based on an individual's or company's ability to earn. Hence both Income Tax and Corporate Tax are progressive in nature.

Another is punitive taxation. Governments tax you not because you are earning - they tax you because you are doing something that is considered a sin, or a moral hazard, or damaging to society, or has negative externalities. Think of alcohol taxes or tobacco taxes or gambling taxes. In these cases, it is normal to tax such that it prevents demand generation of what is otherwise harmful to society in one way or the other. (Same reason short term capital gains is taxed higher than long term capital gains, as the society considers speculation harmful in the long run). Windfall taxes, carbon taxes, etc are all punitive taxation.

There is obviously the opposite of punitive taxation - which are tax incentives. They work in the opposite manner. I am sure you can fill the details.

The larger point is that each country decides what combination of generative taxes, punitive taxes and tax incentives they want to have out there to encourage and discourage economic activity while funding the costs of governance. By doing so, they leave it open for all companies, and individuals, to play the game they so desire based on the rules.

If Non-Renewable Energy companies are doing so, and the government is unhappy over it, then they should change the rules of the game and not target a particular sector.

The patron argument

There is an argument that Non-Renewable Energy companies don't succeed without the help of diplomacy and government intervention - imagine BP being able to operate without oil diplomacy with various state actors across the world. If they are to succeed because the government helps them through their diplomatic efforts, shouldn't the government be able to tap into their coffers when needed to pay for something?

This argument can be rebutted across two directions - (a) they aren't the only ones to benefit from geo-political stances, many other industries including defence and aviation earn their income through similar support and (b) if they didn't want these companies to be treated as a fair private sector player and offer a level playing ground, then they should nationalise the players instead of letting them be private and finding backdoors to funding their needs when they arise.

The arbitrariness of it all

The second major problem with the windfall tax is its arbitrariness. There is no policy statement on what would happen if an Non-Renewable Energy company in the near future were to generate a loss - would the Chancellor be willing to provide an enhanced tax credit, the equal and opposite of enhanced taxation when profits are perceived to be high?

When Singapore’s metro operator SMRT had capex issues, the government (through its arms) was willing to fund it by capping the EBIT to no more than 5% margins, with a floor of 1.5% margin, if I recall correctly. (note: When they saw that shareholders were not happy about it, they nationalised the company altogether by buying out the shareholders)

Something more broad-stroke like that, where the government chooses to floor and ceiling the margins the Non-Renewable Energy sector companies in the UK would at least seem a bit long-term and allow various participants to think about how to support the remnant demand for fossil fuels while funding the energy transition to renewables.

What can go wrong?

Quite a bit, in my opinion.

Firstly, as an energy policy, this is a bad idea, as it will discourage investments in the North Sea and move investments abroad. Where is "abroad"? Mostly in lands dominated by one dictator or the other. In effect we are swapping the outcomes of one energy crisis with the possibility of another one in the future - seems like an example of myopic decision making.

Secondly, from a corporate taxation perspective, it is going to leave shareholders and investors double-guessing their ability to extract returns when the government arbitrarily chooses a profitable sector to extract more whenever they so choose.

Why is this happening?

Unless someone is roaming the corridors of Downing Street, it is difficult to ascertain why this is happening. However, the proximity of the release of the Sue Gray report and this decision casts aspersions that likely the PM-Chancellor duo are feeling the heat on Partygate and taking whatever steps necessary to give themselves breathing room to fight opposition. In that scenario, what better to take steps on what is considered the burning issue of the day by doing what the opposition has been suggesting already?

It is even more interesting that Bojo-Sunak arrived at the decision of using windfall tax despite initially opposing the move.

Alternatives & Summary

As mentioned in the post above, there are alternatives depending on what the objective is.

If the objective was energy transition, either a tax on fossil fuel demand, or a forced investment by fossil fuel companies on energy would have been better. If the objective was to reduce windfalls in general, then taxation above a certain absolute value of corporate P&L could have been introduced. Finally, if the objective was funding the energy bill reduction program, a fairer method would have been to increase taxes in general - something that the Tory manifesto doesn’t allow. Hence, they keep raising taxes just in one form or another. I am not sure if the PM and the Chancellor consider the public that unwise - that they won’t be able to see through the various tax moves that have come in since they have come in power. Sure, there are justifications for all the moves, but the manifesto has still been broken, regardless of what they may claim.