What is the right tax rate for fracking in the UK

Martin Hearson has written an interesting blog on the proposed tax regime for gas produced by fracking in the UK and questioned whether it is necessary to offer the incentives for this activity. Britain’s fracking tax incentives: do they pass the test? He says:

“First, will there be a published, transparent analysis of the revenue expected to be foregone, and predicted benefits? This is usually done in the UK through a “tax information and impact note” attached to proposed legislation, but I wonder how detailed it will be, and whether there will be any way to test the assumptions about how much investment the incentives will bring in. Peter Lilley, a conservative MP with an industry background, said yesterday, “I think tax breaks are unnecessary for fracking, based on my knowledge of the oil and gas industry.””

“Second, from the “most competitive in the world” headline, it seems these British incentives are not simply designed to tip the investment past the point at which it has a viable net present value, but quite explicitly to entice investment away from other countries. So it’s tax competition. Why isn’t there a statement that incentives should only be designed to make investments viable, as opposed to making already-viable investments more attractive than those in other countries? Is that too vague?”

Now I don’t do any work for anyone involved in fracking and I probably share many of the concerns about its viability in the confines of a small island. But I think we have to think about what is the right resource rent to charge for this resource. I worked in the Oil Taxation Office at the beginning of my career and worked on the way the oil and gas regime changed to both incentivise production and collect the appropriate rent for the resource and what was clear was that the rent changed depending on whether one was trying to encourage investment or dealing with a mature resource province.

Its important to remember that Gas is not Oil, although Oil liquids in Gas can introduce some oil like characteristics.  Wood Mackenzie have  illustrated the relative values for gas compared to an oil price of $100.

LNG prices reflect a discount for transportation to the market and regasification. Before the producer receives this price the midstream operation needs to recover costs and make a return. Finally, domestic prices for gas are lower still than this so $100 oil results in $20 gas. Added to this are the other characteristics of the gas market. Gas in most parts of the world is sold under long term contracts which impose long, flat production profiles which reduce the present value of production.

In his summary in Taxation of Petroleum and Minerals 2010 ( Daniel & Keen) , G Kellas concludes:

“Gas projects may require more attractive fiscal terms than oil projects as a result of lower profitability; caused by lower energy equivalent prices; higher transportation costs and longer, flatter production profiles. Fiscal terms which are progressive and linked to project profitability could apply to both oil and gas and the level of government take will automatically be lower from less profitable projects.”

A further contributor is that resource rich governments will often direct gas produced towards the domestic market whilst seeing oil as primarily a source of export earnings. This can lead to a desire to seek lower resource rents for gas in an attempt to keep domestic gas prices low both for electoral and competitive reasons.

So why does the government want to encourage fracking? Well, I think in part that they have seen the impact which fracked gas has had on prices in the US. The spurt in supply has not surprisingly lowered prices providing US business with a competitive advantage against other countries given the significance of energy prices as an input cost. If more gas can be produced economically from fracking could the same thing happen in the UK? If that was the case, given that gas will be used domestically then perhaps charging a lower resource rent makes sense.

One final point is that the tax rate applied to coal in the UK is the corporation tax rate (the low 20s). Fracked gas will be taxable at 30%. Should we not think about what is the right tax rate for coal given its environmental effects?

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