Today, in his budget the Chancellor announced two developments which should pave the way for billions of pounds of future investment into the North Sea. After the shock of the 2011 increase in the supplementary charge, the 2012 budget represents the outcome of a much more positive engagement over the last year between Government and industry to tackle the issues of working in a mature basin.
Decommissioning security – the impact of uncertainty over tax relief
Decommissioning presents one of the largest challenges for companies wishing to invest in North Sea oil exploration and production. Future costs are currently estimated at around £30 billion, as many offshore installations near the end of their working lives. Certainty over tax relief will ensure that the North Sea remains attractive to investors and is likely to be welcomed in an industry where fiscal instability has led to concerns over growth and where exploration activity has halved and annual production activity has fallen by 18 per cent over the past year alone.
Within the UK, in order to ensure that older structures are decommissioned, legislation provides that all of the owners of an installation are jointly and severally liable to decommission it at the end of its life, and if they fail to do so the Government can look to former owners (and other associated parties) to meet the cost. Because of this joint and several liability owners often enter into a decommissioning security agreement with each other, to ensure they can meet their individual liabilities for decommissioning costs or, if they sell out, enter into similar agreements with the purchaser of their interest in the field to ensure they are never called back to fund decommissioning if the purchaser defaults.
Under such agreements, each partner (or the purchaser in a sale situation) must provide security to meet its decommissioning liabilities, often by way of letter of credit, which will be held until such time as it may be needed to meet decommissioning costs. Banks issuing letters of credit will very often require the party giving security to provide collateral, tying up funds which could otherwise be invested in oil and gas developments.
The current UK tax regime allows for tax relief on decommissioning costs only at the time that decommissioning takes place. This provides little comfort for industry players seeking security since they have no guarantee that the rules will still allow such relief when decommissioning of their field occurs, and if so to what extent, and what the eligibility criteria for tax relief may be at that time. It is also a concern that companies may not have sufficient taxable profits in the UK at the time of decommissioning in order to be able to claim tax relief.
Therefore they require security to be provided on a pre-tax or “gross” basis without taking account of the potential for tax relief to ensure that adequate funding for decommissioning exists in the event of changes to the current taxation regime. This means that those providing security have to provide much larger letters of credit than would be the case if the tax regime were stable, consequently tying up even more funds in collateral. The uncertainty also affects those considering whether to invest in their existing assets who will apply cautious assumptions as to the net costs of decommissioning when valuing those investments.
Proposal for contracts to guarantee tax relief
Today, George Osborne has announced plans to ‘lock in’ current rates of tax relief through the introduction of contracts to be entered into between oil companies and the Government. Under such contracts, which were developed by an industry working group in consultation with the Treasury, the entity with which the Government is contracting will effectively be provided with an undertaking that the Government will indemnify them against any future unfavourable changes to the decommissioning tax regime. The contracts could also enable a company with insufficient taxable profits in the UK to claim relief at the time of decommissioning.
The Chancellor has announced plans to begin a public consultation shortly and legislation is expected in the Finance Bill 2013. In an environment where the volume of asset transfers and market liquidity has decreased, such contracts will provide an incentive for lenders to provide finance to companies, free up much needed investment capital for exploration and production and ensure that North Sea asset transfers remain attractive, providing a valuable source of revenue for the Treasury. Oil & Gas UK’s analysis demonstrates that decommissioning certainty will unlock new investment of circa £40 billion, generate an additional 1.7 billion barrels of oil and gas and, over the next five years alone, the Exchequer could receive an extra billion pounds in tax revenue.
Field Allowances extended
The Chancellor also announced today a package of changes to the field allowances, which reduce the amount of profits on which the supplementary charge is imposed. This package is designed to increase investment in fields which would otherwise be commercially marginal; they involve doubling the amount of the small field allowance from £75 million to £150 million at the same time as increasing the size of fields qualifying for the maximum small field allowance to 45mboe (tapering to zero allowance at 50mboe), the introduction of a new £3 billion field allowance targeted at the West of Shetland area (based on water depth and reserve size criteria), and the extension of the allowances to fields that have already received development approval. These changes are expected to take effect following the enactment of secondary legislation and the Finance Bill 2012 later this year.