Taxation could restrict development in the UK oil and gas sector.

A few years ago, the UK got it right – the country simplified the petroleum tax to make it highly transparent, simple to understand, and fair. In the early 2000s the 40% flat tax with 100% depreciation of tax deductions was about as simple a fiscal regime as could be designed. But the gradual ramping up of the supplementary tax rate caused some nervousness around investment as the tax regime seemed unpredictable.

Interestingly, the latest increase to 32% supplementary tax has brought the overall taxation levels to almost the same point as Petroleum Revenue Tax paying fields from the 1990s. This was an odd choice considering the UK North Sea is a mature region in its twilight years.

The government found it necessary to incentivize investment in other ways such as small field allowances and the ring fence expenditure allowance. The incentives have had some remedial effect, but the approach seems ad hoc and is adding complication to what had been a simple fiscal regime.

Increasing the Supplementary Tax was clearly a bad move. It is reminiscent of the Alberta windfall taxes that completely froze investment in gas exploration in that Canadian province and drove drilling dollars to neighboring Saskatchewan and British Columbia. In seeking higher tax rates, inexperienced politicians forget that an active oil and gas industry generates much more indirect tax revenue by keeping local businesses and people employed.

Remove the oil companies’ incentive to keep drilling, and an entire sector of the economy shuts down.

Having recognized the mistake, the UK Treasury is now going down the slippery slope of reversing the damage done by the Supplementary Tax with a patchwork series of incentives, holidays, tax credits, and breaks. Most recently this has been in the form of an extension to the Ring Fence Expenditure Supplement. All this does is add complexity to the tax regime. And eventually it will require additional government staff to administer the legislation. Oil and gas producers will have to spend more time analyzing each new round of incentives to see if they will actually benefit the company. All of this reduces the industry’s willingness to trust the UK government enough to make major investments in the North Sea.

The danger is that investors will look elsewhere for stability.

The UK Treasury has a long way to go before it is in the same league as Nigeria with respect to tax regime instability; however, the recent UK policy changes are taking a step in that direction. Nigeria has the luxury of having a wealth of exploration potential; the UK does not.

Overall tax rate without any deduction or allowances. (Image courtesy of Palantir Solutions)