The EPL makes upstream oil and gas developments unattractive under a range of scenarios, write Professor Alex Kemp & Arturo Regalado in the Spring 23 edition of Offshore Energies UK's magazine.

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The Energy Profits Levy (EPL) was introduced by the UK government May 26 2022 to tax the profits of oil and gas companies operating in the UK Continental Shelf (UKCS). The tax involved a temporary 25% levy on oil and gas profits in the North Sea. This was in addition to the existing Corporation Tax of 30% and the Supplementary Charge of 10%. The plan was that the EPL would expire by December 2025. However, in the Autumn Statement of November 17, the EPL was increased to 35% from January 2023, and its duration was extended to March 31, 2028. The EPL also includes extra investment allowances so that for eligible expenditure the amount of tax saved for every £1 invested is just over 91 pence.

To ascertain the effects of the windfall tax we have constructed a discounted cash flow model and applied it to three representative fields of recent vintage. The investment and operating costs of the three fields and the related production profiles are based on different reports from the North Sea Transition Authority.

To assess the effects of the EPL on investments we employed oil prices representative of those known to be employed by investors in the North Sea. Our modelling examined the effects of both the initial EPL scheme and the second one.

These effects were found to depend critically on the timing of the investments and whether the investor had taxable income available when the investments were
undertaken.

Our analysis found that the investors developing the fields prior to the introduction of the EPL, but who had other income against which to set the various allowances, would suffer significantly greater reductions in post-tax returns with the 35% rate compared with
the 25% rate. The precise effect was found to depend on the extent to which the investment allowances at the high rates could be fully used. Thus, a development
project starting in 2019 would not be able fully to utilise the high rates of relief which only started in 2022.

Further, our modelling demonstrated that a project which had investments commencing before 2022 would be highly exposed to the higher rates of tax on income from the introduction of the EPL.

An incentive effect on investors could be to undertake new field investments in the duration period of the EPL and to ensure that the bulk of the production revenues
occurred after the expiration date of the EPL.

With respect to investment projects starting in 2022 or later, but within the duration period of the EPL, the effects again depend critically on the extent to which the investor has income readily available against which to set the various allowances. In this case the effects of the large allowances were found to increase the post-tax returns to new investments above those before the EPL was introduced. However, our modelling also
found that the effects of the higher EPL rate reduced the post-tax returns compared with the pre-EPL system.

Our modelling also found that the difference in post-tax returns to the projects varied greatly depending on whether investors had other income against which to set allowances. Without such other income, post-tax returns were greatly reduced. In this scenario the returns on typical small fields were reduced to levels which would not be generally acceptable.

From the viewpoint of government tax receipts relating to investments undertaken in 2022, the second levy scheme introduced can result in substantially higher receipts compared with both the pre-EPL scheme and the initial EPL one. The effect depends on
the extent to which profits attributable to the projects commence before the end of March 2028.

It is widely acknowledged that capital rationing currently exists, not only because of the effects of the EPL but also because of the willingness of lenders to provide funds for oil development purposes. In this situation investors can assess projects by estimating the ratios of post-tax net present values over project investment costs. When we undertook
these calculations we found that on small fields the ratio was extremely low and well below that likely to be acceptable in a capital rationing environment.

As noted above the incentive effects of the EPL are to plan investments to take advantage of the various investment reliefs and liabilities. Because decommissioning expenditure is not a deductible item for the EPL, there are incentives to delay
decommissioning work.

Offshore Energies magazine Spring 2023

Notes for Editors