After resisting a windfall tax for several months, on 26 May UK Chancellor of the Exchequer Rishi Sunak announced that the government would implement a tax on oil and gas profits, named the Energy Profits Levy. The Levy followed Ofgem’s announcement on 24 May that the energy price cap is expected to rise to £2,800 in October 2022, which could lead to 12 million UK households experiencing fuel poverty.

The UK is not the first European country to implement a windfall tax. Spain already introduced a tax scheme in September to protect households against rising energy bills and Italy followed in January. In the US, Democrats are eyeing a similar way to act against rising energy bills with a proposal for a new quarterly tax on oil companies.

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“We have the tools and the determination we need to combat and reduce inflation. We will make sure the most vulnerable and the least well off get the support they need at this time of difficulty,” said Rishi Sunak in a speech at the House of Commons as he announced the windfall tax. “And we will turn this moment of difficulty into a springboard for economic renewal and growth.”

Under the new support package that the windfall tax is part of, every household in the UK gets £400 of support for energy bills. This is double the amount of an earlier rebate scheme announced in February and, unlike that proposal, the £400 doesn’t have to be repaid.

Additionally, around eight million of the lowest income households will get a one-off cost of living payment of £650; eight million pensioner households who already receive the Winter Fuel Payment will get £300; and six million people who receive disability benefits will each get £150. To cover people who might struggle with energy bills but are not specifically included in the extra payments, the Household Support Fund from local authorities is being extended by £500m.

The announced measures total £15bn. Part of the support package will be financed by a 25% tax charged on the profits of oil and gas companies, bringing the total tax on oil and gas profits to 65%. Sunak expects the tax to bring in £5bn. The remaining £10bn of support will be covered by extra borrowing, according to the chancellor.

After the windfall tax was announced, BP said that the company would review its North Sea investments, despite the CEO saying in early May that a windfall tax wouldn’t impact the company’s investments in the projects. BP profits more than doubled to $6.2bn in the first quarter of 2022, the company's highest quarterly profits in more than a decade. Shell, which reported nearly tripled quarterly profits of $9.1bn, said that the levy creates uncertainty about investments for North Sea oil and gas, as well as other future long-term investments.

More investments mean fewer taxes

However, the windfall tax has an investment allowance built-in, meaning that companies will be given an incentive to reinvest the profits. For every £1 a company invests, it will get back £0.91 in tax relief. The more a company invests, the less tax it will pay.

This means that oil and gas companies could use investments to decrease the amount of windfall tax they have to pay, and the government may raise less than the expected £5bn.

“Either the chancellor will raise the £5bn he touted, or the oil and gas companies will take advantage of the £0.91 deduction on every £1 invested,” says Chris Hayes, senior data analyst at think tank Common Wealth. “He can't have both.”

It is unclear how the Treasury plans to fill a potential gap in funding, as there is no mention of it in the policy paper. If it’s funded similarly to the £10bn, then it would come out of extra government borrowing.

Common Wealth is critical of the tax loophole, saying that oil and gas companies have “enjoyed handsome state support for long enough”.

“Total taxpayer support for fossil fuels amounted to an average of around £12bn a year over the last five years, including tax breaks for fossil fuel companies worth about £3.1bn in 2019-20, and £2.5bn in 2020.”

Common Wealth calculated the amount of tax relief for both domestic production and consumption of fossil fuels in a special report on fossil fuel support in the UK tax system. They found that despite the UK being part of the Paris Agreement since 2015, the amount of tax relief that fossil fuel receives has not been substantially reduced.

Encouraging fossil fuels investments

Furthermore, the investment allowance was included to encourage companies to invest specifically in oil and gas extraction in the UK, according to the policy paper.

“Instead of recognising the urgent need for large-scale direct public investment in green energy, the chancellor has opted to reaffirm his nonchalance regarding the climate emergency and his apparent belief that public money should only ever be spent securing paltry concessions from big business,” says Hayes. “Energy is too essential to be left out of public hands.”

According to analysts from research company Wood Mackenzie, the new tax is unlikely to render new or existing North Sea projects uneconomic, contrary to what oil and gas companies say, and it could even accelerate the development of projects in late stages, such as the Rosebank and Cambo oil fields.

“The timeframe could be enough for some discoveries, currently awaiting a final investment decision, to be developed with the bulk of costs receiving this tax relief,” said Graham Kellas, senior vice president of Global Fiscal Research at Wood Mackenzie in a news release.

Gas producer Serica already announced that they will ramp up investments to offset tax. The company had already planned to invest around £60m in 2022 and is evaluating investments in additional projects.

Committing to additional gas and oil extraction projects now could have negative consequences for reaching net zero. A special report from the International Energy Agency said that to reach net zero by 2050, there should be no further investments in new fossil fuel supply projects.  

Extending to electricity generators 

Electricity generators were left out of the initial levy, but Rishi Sunak has hinted that the tax could be extended to electricity companies as well due to the “extraordinary profits” that are being made in the sector. 

Energy UK, a trade association that represents the energy sector, has warned against an extension of the tax as it could further discourage investments in renewable energy projects. They said that the industry is investing more than £100bn in new energy sources over this decade, but that a windfall tax “could delay and increase the costs of these investments”. 

Analysts from market researcher Cornwall Insight similarly warn against including electricity companies and urge instead to look for other ways to help vulnerable households, such as a social tariff or investing in more permanent solutions such as energy efficiency.  

“With millions of people in the UK currently in fuel poverty, some may rightly ask, without a windfall tax, how we fund support for vulnerable consumers,” says Dan Atzori, research partner at Cornwall Insight. “Besides giving all consumers small discounts to their energy costs, there are multiple, more sustainable options available that target support at those most in need.”