Fossil fuel boom profits not being taxed to fund transition: study

Fears over high fossil fuel prices have led governments to slash taxes on their use when instead they should be diverting taxes on the sector to the energy transition, according to a research group.

Germany-based group Climate Action Tracker (CAT) in an 8 June report looked at the ways governments responded to the invasion of Ukraine by Russia, supplier of 25% of global natural gas exports, and the related increase in natural gas and oil prices.

Countries have moved fast to ease the burden of high fossil fuel prices by adjusting taxes for consumers and energy sector companies.

To secure alternative energy sources, governments boosted oil and gas production, added fossil fuel imports deals, and set higher renewable energy targets. The UK added 10 GW to its target for offshore wind and the EU added the equivalent of 169 GW to its renewable energy goals.

But CAT said these additions were "far from sufficient," and that governments for the most part backpedaled on their long-term climate mitigation strategies.

"So far, governments have largely failed to seize their chance to rearrange their energy supplies away from fossil fuels. Instead, we are witnessing a global 'gold rush' for new fossil gas production, pipelines, and LNG facilities," the group noted in the report.

Some countries announced plans to expand LNG import infrastructure. Since April, new LNG terminals have been announced in Germany, Italy, Greece, and the Netherlands.

New long-term oil, gas, and coal import contracts were closed or extended in the UK, EU, Germany, Poland, and Italy.

Several governments were singled out for "locking us into another high-carbon decade and keeping the Paris Agreement's 1.5°C limit out of reach" by adding domestic oil and gas production. They were the US, the UK, Qatar, Australia, Canada, Norway, Egypt, Algeria, Italy, and Japan.

Countries' overall response, said the group, has been as weak as their COP26 climate summit pledges, widely seen as inadequate for preventing an expected 2.7-degree Celsius increase in global temperatures in 2100.

Low-income countries' mitigation efforts may further weaken as they continue to struggle with high prices, while international investors may have less "fiscal space" for energy transition finance, CAT said.

Energy companies have reacted to record high fossil fuel prices that make it more profitable to invest in new infrastructure by "reassessing the changing investment landscape."

Windfall tax as energy transition opportunity

Now "almost all" governments are compensating consumers for high energy bills, for example through the tax system, according to CAT.

Taxes that shield consumers from high gasoline prices run counter to government attempts to raise electric vehicle purchase numbers. "High gasoline prices increase the competitiveness of alternative modes of transport, making them more attractive to consumers," the report's authors noted.

So far, only a handful of governments have rolled out windfall taxes diverting record profits made by fossil fuel, renewable, and/or nuclear sector companies amid the energy crisis: the UK, Italy, Spain, Bulgaria, and Romania.

In Europe, the practice was promoted under state guidance in the EU's 8 March REPowerEU communication that sought to lower energy prices for EU consumers and businesses.

In the UK, a temporary windfall tax on oil and gas producers was announced on 26 May, the Energy Profits Levy. A broader windfall tax in Italy also captures oil and gas producers.

But while the pair of windfall taxes will go to consumers, they are not being used to finance renewables and energy efficiency. "The EU provides a structure as to how it could be done, which could be rolled out to more countries," wrote CAT.

The group pointed out other taxation structures might raise funds for renewable and cleantech investment. For example, carbon pricing could be introduced when prices fall again without threatening consumers, it said.

Denmark was the only country announcing plans to increase and expand its existing carbon tax on oil and gas production in its response to the energy crisis in April.

At the same time, Danish Prime Minister Mette Frederiksen announced plans to increase North Sea oil and gas production to increase supplies. After this, all production must be phased out by 2050.

Oil production not disincentivized

The UK windfall tax incentivizes the expansion of investment in oil and gas over renewables.

Producers subject to the windfall tax on their profits will enjoy a sizeable 91% rebate (known as an Investment Allowance) based on money spent on oil and gas projects.

Such investments were previously foreseen in the UK's upcoming North Sea production licensing round announced in April as an energy security measure.

"Instead of driving money into clean energy solutions, the chancellor has chosen to pour fuel all over the climate crisis," Greenpeace said of the windfall tax.

KPMG Head of Energy Tax Claire Angell in a blog argued the windfall tax would reduce the attractiveness of investment in the UK.

However, the windfall tax is not expected to have a long-term impact on producers before being phased out at the start of 2026. "It is difficult to gauge the effect of the tax on production volumes. My instinct is that it will not make much difference when compared with other factors. Those impacted by the tax will tend to be the big players in the industry and I would not expect a significant impact outside the short term, especially as the pain caused by the tax is intended to be time-limited through the sunset clause," Keystone Law Partner Andrew Terry told Net-Zero Business Daily by S&P Global Commodity Insights.

"The UK has imposed windfall taxes before, especially in war time, such as excess profits tax in World War 1 at a rate of 80%. More recently in 1997, the Blair government imposed a windfall tax on what were described as 'the excess profits of the privatized utilities,' which raised an estimated £5 billion," he added.

Only 35 oil and gas groups have paid UK corporation tax in recent years because of various allowances and write-offs, Terry noted.

CAT observed fossil fuel production globally is currently incentivized by high oil prices. The UK government, rolling out the windfall tax, said that a doubling of oil prices (and more than doubling for gas) led to "significant increases in profits earned from UK oil and gas extraction."

Certain oil companies have recently recorded their highest quarterly results in a decade, a study found, with the 28 largest oil companies making $100 billion in profit combined in the first quarter of 2022.

This article was published by S&P Global Commodity Insights and not by S&P Global Ratings, which is a separately managed division of S&P Global.