Issue Number: 96   May 2013

An Unconventional Budget?

We consider two major developments that escaped the front page.

March's UK Government budget offered a mixture of continuing austerity and crowd-pleasing policies not to mention a forecast that avoids a 'triple-dip' recession but does not promise much more than weak growth. In amongst the scrapping of duties for two of our favourite consumable liquids, beer and fuel, were two major developments for the oil and gas industry that escaped the front pages of the national newspapers. This article will provide analysis on the potential effects of the policies.

The first of these two policies was a display of George Osborne's continued commitment to the development of shale gas in the UK. Having previously signalled an intention to promote investment in the industry via 'generous' tax breaks, as covered in past MZINEs, the Chancellor used the Budget to not only reiterate that desire but to resolutely state that 'shale gas is part of the future and we will make it happen.'

The second policy was a confirmation that the tax and legal regime for decommissioning expenses, which will see tax relief for the costs of shutting down ageing North Sea pipelines and platforms, has been largely agreed and a commitment that it will be implemented in 2013, through the Finance Act. The oil and gas industry has been waiting for this statement since 2011 when Osborne stated that tax breaks on field abandonment would be limited. The Government has argued that this new contractual approach will provide further certainty, and thus increase investment.

Shale Tax Breaks

In an effort to bring the shale gas revolution to the UK, George Osborne has pledged to introduce a 'generous new tax regime' for shale gas. These tax breaks will be introduced in the form of a new shale gas field allowance. Additionally, the ring-fence expenditure supplement will be extended from six to ten years for shale gas projects to promote investment at an early stage of its development.

The 'new field allowances' have been described as one of the success stories of the North Sea regime in recent years, and it is reported that the tax rate for some of the shale gas production will be reduced from 62% to 30%. The increased length of the ring-fence expenditure supplement takes into account the long lead-in times for shale gas projects, allowing companies to increase the value of losses carried forward. This will effectively allow companies to 'inflation proof' their project and help those with no taxable income against which they can offset their costs.

The Government is also planning to introduce this summer guidance on technical planning and proposals to ensure local communities benefit from shale gas projects in their area. Lastly, the Government has also committed to provide details of objectives, remit and responsibilities of the Office of Unconventional Gas and Oil.

If the success of Osborne's latest attempt to encourage investment is to be judged by the initial reaction of those companies who will likely invest then this policy is a triumph. Francis Egan, Chief Executive of Cuadrilla, the company leading the efforts to develop UK shale fields, released a statement warmly welcoming the announcements, noting that:

"At this early stage of the industry's development, the Government's decision to introduce tax reforms for shale gas will greatly incentivise companies … undertaking and investing in exploration work."

Egan also praised the acceleration of provision of planning guidance for local authorities as well as the recognition that local communities must reap long-term benefits from shale gas [1]. Of course, it ought to be noted that neither of these latter proposals have been properly developed yet so how local communities will actually benefit cannot be quantified.

However, whilst many in the oil and gas industry have praised Osborne's creation of an investor friendly climate, there are those who feel his tax breaks would be better spent on the renewables sector[2].

Arguably, the UK possesses the tools to lead the way in the EU in both shale gas and renewables. Unfortunately, it appears that it is struggling to run both races simultaneously. Nonetheless, Osborne's persistence in bringing shale gas to the UK could prove vital for the economy in the coming years.

Decommissioning

In addition to the support of investment in new shale reserves, the Budget is also seeking to support investment in the UK Continental Shelf (UKCS) by providing further certainty on decommissioning tax relief on the UKCS. The Chancellor announced that contracts will be signed later in 2013 following two years of negotiations between the Government and the oil industry.

With the Government seeking to avoid the constitutional difficulties that might arise from one Government binding future Governments not to change the law, the solution has centred on a form of contractual arrangement with field owners. This contract can offer a guarantee to companies, either selling or purchasing, that they will get their tax relief. Whereas previous tax reliefs might not necessarily be binding in the future, this contract will be. The strength of this new method is that it is able to act as a stronger vehicle for the Government's intentions and actually guarantee relief and thus encourage investment.

The issue over how to remove the uncertainty surrounding decommissioning relief has been outstanding for some time. Although tax relief on decommissioning has been available, there has never been any guarantee that it would be available when needed. Under UK legislation, the owners of infrastructure at the end of its useful life are jointly and severally liable to decommission it, meaning that if any owner defaults, the others are obliged to pay their share. To complicate matters, if all owners default then a wide range of people including former owners are potentially liable to pay for decommissioning. Due to these various liabilities, partners and sellers often require Decommissioning Security Agreements (DSAs) from other owners and purchasers providing security against the risk of defaulting on their decommissioning obligations. The security is usually a letter of credit from the bank, backed up in funds. The interesting part of this is that potential tax relief is not being taken into account when calculating security because it cannot be guaranteed, meaning the funds required for security are significantly higher than they would be if tax relief were guaranteed.

Therefore the disincentives for new investors to buy more mature fields and current owners to prolong existing fields appear twofold. Firstly, more capital is being tied up in security and secondly, there is a risk that existing relief might be lost in the future as a result of law changes. The result of guaranteed tax relief offered in contracts should mean that the cost of security decreases, as it is calculated on a cheaper post-tax basis as opposed to the current pre-tax method, whilst the certainty of future decommissioning costs increases, meaning that previously tied up capital free to be invested. It should also allow companies to sell on their more mature fields to smaller companies who can maximise the recovery of oil and gas from those fields and delay de-commissioning (see graph below). To give an idea of the amounts of money that could be saved, the consultation paper on Decommissioning Relief Deeds states that in non-Petroleum Revenue Tax (PRT) fields[3] tax relief is currently available at 20% for Supplementary Charge, and 30% for Ring Fence Corporation Tax. The rate of relief in PRT fields is up to 75%.

Once again, the reaction from the oil and gas industry has been positive, with Decom chief executive Brian Nixon stating that the "confirmation of tax relief through Decommissioning Relief Deeds will help ease one of the greatest concerns facing the North Sea industry and lead to investment and ultimately more jobs." Perhaps more importantly, there have already been strong indications that investment has increased, with Oil & Gas UK stating that there will be a rise in investment in new fields from £11.4bn in 2012 to £13bn this year. Malcolm Webb, CEO of Oil & Gas UK points out that in addition to new incentives for the exploitation of small and technically challenging fields the increased certainty over decommissioning costs has also played a part in the rise.

Conclusion

The policies contemplated in this article will serve to further encourage investment. Furthermore, the hope is that the tax breaks offered will be more than recouped in jobs created and, somewhat ironically, the increase in tax receipts. Despite a raid on the industry in the 2011 Budget which probably caused many Oil and Gas executives to view Osborne as a villain, the 2013 Budget may well have caused those same executives to now view him as an ally.

The policy surrounding decommissioning seems to be an all-round positive move for all involved. Providing the final contracts can properly carry out the Government's intentions of providing decommissioning tax relief without increasing the cost or allowing companies to gain unintended advantages, the only real consequence should be increased investment.

However, the final effect of tax breaks for the shale industry will remain to be seen. The incentives to invest are undoubtedly beneficial to those in industry. However, the actual effect shale gas might have on the market is yet to be determined, although it should be pointed out that the UK is unlikely to replicate the US. Environmentally, 'fracking' is an emotive subject. If it can be accessed in a safe, responsible manner then the downsides are limited, noting that it emits significantly less CO2 than the fuels it is likely to replace, coal and oil. The upside, on the other hand, is impressive with the long-term benefits of a reduction in reliance on imported gas, the creation of thousands of jobs and the generation of significant tax revenues. As a result of this upside, it seems fair that Osborne should try and encourage the market to flourish where possible.


[1] http://www.cuadrillaresources.com/news/cuadrilla-news/article/cuadrillas-statement-on-the-budget/
[2] http://www.iii.co.uk/articles/81978/budget-2013-tax-breaks-boost-uk-shale-gas-investment
[3] fields given development consent before 16 March 1993

May 2013 MZINE