Memorandum submitted by Centrica (UKOG 13)

 

Executive summary

·         North Sea oil and gas industry is subject to particularly high rates of taxation on profits.  Effective rate increases to 75% as it does for many of Centrica’s fields.  This level is exceptionally high in global terms for a mature oil and gas province.  By comparison rates in the US are 35% and 29% for Alberta in Canada.

·         The fiscal regime must change if the government is to meet its stated objectives to put in place the right incentives to maximise recovery of oil and gas reserves, whilst at the same time ensuring that the UK significantly increases its gas storage reserves to ensure security of supply in an environment of rapidly rising gas import dependence.

·         Government’s latest proposals are a missed opportunity for meaningful change

·         Changes are required in five areas

1.      Buy-out or abolition of the Petroleum Revenue Tax (PRT) regime

o        likely that such a measure would be tax neutral.  Government should take a longer term perspective to the tax take from oil and gas industry, which would support the abolition of PRT

2.       Introduction of investment incentives

o        preferably in the form of capital uplift

3.      Change of use/incentives for development of gas storage

o        development of the fiscal rules relating to change of use of North Sea infrastructure especially to facilitate the development of new gas storage facilities required for security of supply, for example, confirmation of relief for cushion gas

o        Centrica committed to increasing storage in the UK and plans to invest £1.5bn in new capacity but the economics are at best marginal

4.      The Crown Estate charging for new offshore storage facilities

o        Crown Estate, who act as the Government’s agency for offshore leases, has a duty to extract the maximum rents from storage projects.  All signals point to extraction of monopoly rents from storage developers.  Crown Estate should adopt a more supportive approach to offshore gas storage designed to encourage new entrants (as per the recent offshore wind farm precedent).

5.      Decommissioning trust funds.

o        Require exemption of decommissioning trust funds from income and inheritance tax, effectively reducing long term industry capital costs and increasing investment flexibility with no immediate significant impact on the tax take.

 

 

1.      How can the UK’s remaining offshore oil and gas reserves be exploited most effectively?  What barriers are there to exploiting such reserves?

1.1.   The North Sea oil and gas industry is subject to particularly high rates of taxation on profits.  A corporation tax rate of 50% applies to all producing fields (including supplementary charge) and where Petroleum Revenue Tax (PRT) applies, as it does to many of Centrica’s fields, this effective rate increases to 75%.  This level is exceptionally high in global terms for a mature oil and gas province, particularly one where industry investors take all the risk.  By comparison rates in the US are 35% and 29% for Alberta in Canada.

1.2.   To put the existing challenge into perspective in gas, for example, the UK was until very recently self sufficient with the UKCS producing enough to meet the needs of UK industry and consumers.  This self sufficiency has turned around very rapidly.  The UK imported approximately 40% of its gas needs last year, 50% imports are expected this year and around 75% by 2015.  The effect of this growing gas import dependence is that low and relatively stable wholesale gas prices have been replaced by high and volatile ones.  The UK can not rely on gas supplies from Europe, because of the lack of effective liberalisation on the continent, nor is the UK always able to attract LNG cargoes when it needs it the most.

1.3.   Centrica believes that the fiscal regime must change if the UK is to maximise its recovery of oil and gas reserves, whilst at the same time ensuring that the UK significantly increases its gas storage reserves to cope with greater import dependence.  The Department for Energy and Climate Change (DECC) estimates that between 17 and 20 billion boe remain to be recovered from the UK Continental Shelf (UKCS), but the current fiscal regime does not allow sufficient economic incentive for this.  Centrica believes that change to the fiscal regime would promote the long term recovery of the UK’s remaining oil and gas reserves and in this context would ultimately like to see the UK Continental Shelf (UKCS) taxed on the same basis as other industries.

1.4.   This need for change has been recognised by the Government, which initiated a consultative process in the 2005 Pre-Budget Report seeking to ensure that the North Sea fiscal regime is appropriate for the remaining life of the UKCS.  Centrica is supportive of the Government’s willingness to consider change and has been closely involved with Oil & Gas UK in formulating the industry’s responses to this consultative process since its outset.  Centrica was in agreement with the legislative changes enacted in the Finance Act 2008, in as far as they went, and welcomes the continued dialogue with the industry represented by the publication of the government’s latest consultative document. 

1.5.   However, Centrica believes that this latest document misses an opportunity for meaningful change, by focusing on marginal amendments to the regime that do not fundamentally address the needs of the industry.

1.6.   Changes are required in five areas – the buy-out or abolition of the PRT regime, the introduction of investment incentives (preferably in the form of capital uplift), development of the fiscal rules relating to change of use of North Sea infrastructure (especially to facilitate the development of essential new gas storage facilities), The Crown Estate charging for new offshore storage facilities and decommissioning trust funds.

 

2.      How effective is the current fiscal and regulatory regime in which the industry operates?

2.1.   Changes need to be made in five areas

2.1.1.      Buy-out or abolition of PRT

2.1.1.1.The UK’s division of the industry into PRT and non-PRT paying fields is unique in a global context and effectively imposes two special taxes on PRT paying fields (supplementary corporation tax and PRT).  The 75% effective tax rate suffered by such fields makes it very difficult to justify large investments in enhanced oil recovery for low after tax returns. In recent years, Centrica has deferred investment in efficiency improvements on its platforms that would have had the effect of lowering operating costs and extending field life, because those investments could not be economically justified on a post-PRT basis.  In this context, there is a powerful argument that the abolition of the PRT regime would considerably enhance investment in the industry.

2.1.1.2.Furthermore, it is likely that such a measure would be tax neutral for HM Treasury over the medium term.  Within the next decade, the Government expects its net take from PRT to turn negative as the tax relief available for the costs of decommissioning depleted PRT fields exceeds the remaining tax payable on revenues from the last producing PRT paying fields.  This would clearly not be sustainable economically.

2.1.1.3.However, the Government’s focus on the five year Red Book timeframe means that it has not yet reached an appropriate conclusion to development of the PRT regime.  Centrica strongly advocates that the Government should take a longer term perspective to the tax take from the oil and gas industry, which would support the abolition of PRT.

2.1.2.      Capital uplift allowance or other investment incentives

2.1.2.1.The fiscal regime currently permits a 100% first year capital allowance for upstream investment, which enables capital investment expenditure to be offset against profits in the year within which it is expended.  We support industry calls for uplift to this capital allowance, for example to allow £125 of expenditure to be offset against profits for every £100 invested.  This would be a straightforward, equitable and most effective way of boosting North Sea investment.

2.1.2.2.At the right level, we believe that a capital uplift allowance could be mutually beneficial both to the industry and to the UK taxpayer.  We believe that such an allowance would act as an important incentive in attracting more investment to the UK in the face of increasingly stiff international competition for projects and for funding.

2.1.2.3.We further believe that the resulting additional taxable profits generated as a result of additional investment would more than mitigate the fiscal cost of the uplift, maintaining and increasing the total tax take over the medium term.

2.1.2.4.However, the current consultative document appears to back away from such a measure.  Instead HM Treasury proposes only a selective value allowance, targeting mostly small, marginal projects and offering a limited amount of revenue relief only on certain new fields unrelated to the actual cost of development.  We believe HM Treasury has rejected the more comprehensive capital uplift allowance as a result of a focus on the five year Red Book timeframe, a focus that is inappropriate in an industry that is making investments to last a much longer period.

2.1.2.5.To the extent that HM Treasury continues to restrict its incentive proposals to a selective allowance, Centrica would support changes in three areas:

a)      Incentives should maximise production from existing fields as well as new developments

There is more to be gained from maximising recovery from existing fields than there is from developing new marginal sources of oil and gas.  HM Treasury’s proposals for a value allowance appear to incentivise the development of new marginal fields over the exploitation of existing opportunities, ignoring the advantages of existing infrastructure.  Centrica supports a broader capital uplift allowance, which would incentivise both new and existing fields on a comparable basis.

b)      Any value allowance should be linked to development cost

One of the key advantages of a capital uplift allowance is that it directly links the tax benefit to the actual development costs.  Early indications are that HM Treasury will not take the size of targeted investments into account in determining the extent of value allowances.  If the current value allowance proposals are adopted, we are proposing there should be a linkage between the development cost and the value allowance, which would bring some of the same economic incentives as capital uplift, albeit for restricted types of investment and with the tax cash flow benefit deferred.

c)      There should be direct incentives for exploration

There are no direct incentives for exploration envisaged in HM Treasury’s current proposals and it is unlikely that the value allowance will act as a meaningful incentive in this regard. 

This would leave UK poorly positioned at a time when the recent fall in oil prices is expected to lead to a world wide diversion of rig capacity from production drilling to exploration activity.  Centrica advocates that any incentive regime should also provide incentives for exploration.

2.1.3.      Change of use / incentives for development of gas storage

2.1.3.1.After reservoir depletion, there are three main alternatives for the continued use of North Sea infrastructure: gas storage, carbon sequestration and wind farms.  HM Treasury and HMRC have been helpful in removing the worst of the tax anomalies that hindered the reuse of upstream infrastructure.  However in relation to gas storage, Centrica believes that the proposals do not go far enough.  In most offshore projects, storage requires large infrastructure investment. 

2.1.3.2.New gas storage is required for security of supply in the UK now we have become a net importer of gas – a need that has been reiterated by the recent dispute between Russia and the Ukraine.  The total storage capacity within the UK currently accounts for only 4% of annual demand, or around 16 days of average demand.  Germany has 21% of annual demand or 77 days and France 24% or 88 days. 

 

 

2.1.3.3.It is estimated that the UK requires around £8-11bn of investment to gain around 56 days of storage – a level commensurate with the UK’s new found status as a nation dependent on gas imports.  Centrica currently owns and operates Rough storage, Western  Europe’s largest storage facility that is over 70% of the UK’s existing storage capacity.  In the last 12 months we have announced plans for another 85bcf of storage capacity, approximately 70% the size of Rough.

2.1.3.4.Centrica is committed to increasing storage capacity in the UK and plans to invest £1.5bn in new capacity, however, the economics are marginal at best particularly against the backdrop of increased financing costs caused by the credit crunch.

 

2.1.3.5.Whilst there are a number of projects in the pipeline, only a small amount of new storage capacity has come on-line in the last few years against a back ground of a number of storage projects recently reporting delays.

2.1.3.6.There is a great deal of uncertainty about the availability of tax relief for certain capital costs, not least cushion gas (the base level of gas required to remain in the reservoir to maintain pressure and permit efficient evacuation of gas).  Cushion gas, which represents a substantial part of the capital cost of a new storage facility, has no economic value other than as a result of the pressure it provides.

2.1.3.7.Many storage projects based their economics on the precedent recently set by the Humbly Grove storage facility that qualified for capital allowances, though storage projects will only receive 10% writing down allowances for tax at best.  Unfortunately HM Revenue and Custom (HMRC) has yet to confirm whether or not storage facilities qualify for such relief.  Industry legal evidence was provided to HMRC in 2009 (letter from Gas Storage Operators’ Group) to confirm eligibility status to no avail.

2.1.3.8.Given the Government’s stated ambition to develop significant indigenous gas storage in the interests of lower, more stable prices to the UK consumer, Centrica would strongly advocate the development of fairer tax relief for the capital costs of storage development and particularly the cost of cushion gas.

2.1.3.9.The current softening of demand may provide UK consumers with a respite from recently high and volatile markets.  However, forward prices for wholesale gas next winter are still 53 pence per therm, which is 20 pence or 60% higher than it is today, indicating that any respite will only be temporary.

2.1.3.10.        Centrica recently announced that its Baird storage project could be on-line in 2013.  The length of time to develop storage projects means that action needs to be taken now if we are to have sufficient storage capacity in place when, for example, the UK is expected to be importing 75% of its supplies around 2015.

2.1.4.      The Crown Estate charging arrangements

2.1.4.1.The Crown Estate, who act as the Government’s agency for offshore leases for storage facilities, have a duty to extract the maximum rents from storage projects.  All signals point to the extraction of monopoly rents by The Crown Estate from storage developers.  This approach is in direct conflict with the government’s broader energy policy and its desire for increased security of supply.

2.1.4.2.The Crown Estate should adopt a more supportive approach to offshore gas storage designed to encourage new entrants (as per the recent offshore wind farm precedent).

2.1.5.      Decommissioning trust funds

2.1.5.1.Along with the majority of the industry, Centrica relies on letters of credit to satisfy its guarantees of future decommissioning costs associated with current producing fields.  These represent a real cost to the business, which becomes more expensive as decommissioning approaches.

2.1.5.2.Earlier this year, a new standardised model was developed with PILOT, a joint programme involving the Government and the UK oil & gas Industry, for calculating the level of decommissioning security required by each North Sea participant.  This model (the decommissioning cost provision deed or DCPD) is progressively being introduced to joint operating agreements, with requirements to be backed by letters of credit.

2.1.5.3.However, the DCPD is actually based on the amount that would be required if deposited in a trust fund.  Income within trust funds is taxed at 40% and trust funds are also subject to inheritance tax.  The amount that needs to be set aside in letters of credit is higher than commercially necessary as a result, tying up capital that could otherwise be used for investment.  Centrica advocates the introduction of clearly defined rules that would exempt DCPD trust funds from income and inheritance tax, effectively reducing long term industry capital costs and increasing investment flexibility with no immediate significant impact on the tax take.

2.1.5.4.In the absence of the necessary reform it is likely that industry will revert to the previous practice of bespoke agreements.  This would miss the prospect offered by a standardised agreement, namely that of facilitating the efficient transfer of assets between industry participants.  The transfer of assets helps ensure that new operators are able to take up the opportunity to maximise reserves where otherwise the fields would be abandoned by their existing owners.

 

March 2009