Pennsylvania has a long history of producing natural gas from a large number of conventional shallow low-production wells, principally for domestic household use. Only Texas has more currently active wells.[1] Pennsylvania ranks 15th in natural gas production among U.S. states, and it is the largest producer without a severance tax.

The advancement of drilling technology and water treatment has strengthened the economic viability and long-term return on investment of extracting natural gas from the Marcellus Shale formation. Marcellus Shale is a unit of marine sedimentary rock found in eastern North America. It extends throughout much of the Appalachian Basin extending across West Virginia; western Ohio; western, central, and northeastern Pennsylvania; southwestern New York; and small portions of Virginia and Maryland.[2] The shale contains largely untapped natural gas reserves that, according to several studies, could conservatively supply U.S. consumption for nearly two decades.[3] The Marcellus Shale formation is estimated to be 10 times larger than the Barnett Shale formation in Texas and is attracting attention from major Texas-based natural gas production companies and big oil companies. The Pennsylvania General Assembly is now considering several proposals to enact an extraction tax that parallels the tax imposed by other shale-gas-producing states, including West Virginia, Texas, and Arkansas.

On July 6, 2010, Pennsylvania Governor Edward G. Rendell signed Pennsylvania Act 46 into law, representing the Commonwealth's fiscal code for the year ending June 30, 2011. Under one of the terms of this Act, Pennsylvania's General Assembly committed itself to passing a severance tax on the extraction of natural gas by October 1, 2010, to be effective no later than January 1, 2011. This commitment represents the culmination of more than 18 months of debate on whether Pennsylvania should levy a tax on the extraction of natural gas from the Marcellus Shale and how that tax should be structured.

On September 20, 2010, the Pennsylvania House of Representatives began a long-awaited day of floor debate over the natural gas extraction tax. A key point of debate within the Democratic controlled House is how much of the severance tax revenue should be earmarked for the Commonwealth's general fund. State Senate Republican leaders have begun drafting legislation for a sweeping overall of Pennsylvania's oil and gas laws and limitations on municipal zoning authority that effects drilling. Republicans have sought input from environmentalists groups, industry officials, and local government advocates. The Republican proposal includes new rules for "pooling," which could be used to force landowners under certain conditions to lease their subsurface gas rights to existing drillers in the area. The Pennsylvania Marcellus Shale Coalition hired former Pennsylvania Governor and first Director of Homeland Security Tom Ridge to sell the public and elected officials across Pennsylvania on the benefits of developing the natural gas industry in the Marcellus Shale formation.

With the November 2, 2010 Pennsylvania gubernatorial election heading into its final campaign weeks, the political environment among the candidates is drawing sharp debate. The Republican candidate for governor, State Attorney General Tom Corbett, has repeatedly said he will not raise any taxes if elected. Democratic candidate Dan Onorato, Allegheny County's elected chief executive, supports a severance tax but has not released any plan. Onorato supports a tax to raise money for environmental enforcement, maintenance of infrastructure in communities affected by the drilling, and the preservation of open space. With only a few days left in the legislative session, Governor Rendell has stated that it is unlikely the lawmakers would pass a tax by the October 1 deadline.

Although 39 states currently have some type of severance tax, including taxes on both coal and natural gas, Pennsylvania, which has long been a major coal producer, has never imposed a severance tax on coal, natural gas, or any other natural resource. While this legislative agreement to pass a tax is a significant first step toward the eventual enactment of a natural gas severance tax law, much remains to be determined during this gubernatorial election year, including the structure, rate, and exceptions to the severance tax.

The Issue in Context

A severance tax is a tax imposed on the extraction of a state's natural resources. In various states, severance taxes are charged for removal of natural resources including natural gas, coal, timber, and salt. In the case of a severance tax on natural gas, the tax is generally payable by both the gas well operator, who extracts the natural gas, as well as anyone else with a working or royalty interest in the natural gas.

The fact that significant amounts of natural gas exist underneath most of Pennsylvania has been known for some time. In 2002, the United States Geological Survey estimated that as much as 1.9 trillion cubic feet of gas existed in the Marcellus Shale. However, that gas was spread over a large area, and, until recently, the technology did not exist to profitably extract the gas. Recent advances in technology, along with anticipated future increases in natural gas prices, have significantly brought down the real and perceived costs of extracting natural gas from the Marcellus Shale, leading to a speculative investment and production boom during the last few years.

Shale formations, such as the Marcellus Shale, are not unique to the northeast United States. Early advances in natural gas extraction from shale formations occurred in the Barnett Shale located in Northern Texas. Techniques developed to extract natural gas from the Barnett Shale have since been successfully employed in the Fayetteville Shale in Arkansas and the Haynesville Shale in Louisiana along with the Marcellus Shale. Drilling companies hope to expand this technology to extract natural gas from previously ignored natural gas plays around the world.

Along with the possibility of significant natural gas production in Pennsylvania comes the possibility of additional revenue for the Commonwealth. In February 2009, Governor Rendell announced that he would seek the imposition of a severance tax on natural gas produced in Pennsylvania. Since that announcement, the tax has been the source of vigorous debate.

During the current 2009–2010 legislative session, there have been numerous separate bills introduced in the Pennsylvania House and Senate proposing various forms of a severance tax. The debate has been divided along traditional lines, with environmentalists and Democrats largely supporting a higher severance tax, while industry and Republicans seek lesser or no taxation. With the passage of Pennsylvania Act 46, it seems likely that some form of tax will be imposed, and the debate has shifted to the proper structure, rate, and distribution of the tax.

Tax Structure and Rate

Pennsylvania, like many states, is facing a substantial budget deficit as a result of shrinking stimulus funds, rising pension costs, and declining tax revenues. The Commonwealth needs to generate new sources of revenue or drastically cut spending to balance its budget. Both gubernatorial candidates, Corbett and Onorato, have cited wasteful spending as a principal basis for reform under new leadership. An extraction tax is one of the few options available that will not constitute an across-the-board tax increase on all Pennsylvanians. A major policy question at this juncture, apart from the environmental risks, is whether or not a severance tax will negatively affect the growth of Pennsylvania's natural gas industry and the incentives for the creation of jobs, and enhance the Commonwealth's general fund. The Penn State Institute for Research in Training & Development released a study on September 13 entitled Benchmarks For Assessing The Potential Impact Of a Natural Gas Severance Tax on the Pennsylvania Economy. The authors conclude that a severance tax on natural gas in Pennsylvania would increase costs for gas drilling companies, but the resulting increase in spending of state revenue could yield positive, but small, impacts on the Commonwealth's economy and population.

Severance taxes are traditionally assessed based on the volume or value of gas extracted, or a combination of the two. There are advantages and disadvantages to each method.

The most simple structure is to assess a tax based on the volume of gas extracted from the ground. In this type of tax, flat rates are charge in cents per MCF (thousand cubic feet). The gas is metered through the well as it is extracted, and the well-driller pays a tax based on the amount of gas piped out of the well. The problem with this type of tax is that it does not account for the fluctuating price of natural gas. When the price of gas is relatively high, gas producers gain a windfall, while the Commonwealth is left without benefit from the higher prices. On the other hand, when prices are low, a volume-based tax can become prohibitively expensive for producers.

An alternative tax structure is a tax on the value of the gas extracted. These value-based severance taxes are applied to the value of the gas "at the wellhead." (This term means the value of the gas itself at the point of production, before accounting for transportation and distribution costs). This value-based severance tax fixes the problems associated with a volume-based tax, but it creates some new issues of its own. While the volume of gas extracted can be accurately predicted, revenues from a value-based tax are much more difficult for state budget-makers to forecast since the revenues collected fluctuate with the energy futures market. Value-based severance taxes are also more costly to enforce. Rather than just monitoring the well meter, as is done with a volume-based tax, regulators must monitor sales.

In an effort to balance these issues, many severance taxes represent a hybrid of the two different forms of taxation. In these hybrid tax schemes, the taxing authority charges a flat-volume tax at a relatively low rate and then charges an additional tax on the value of the extracted gas. This hybrid structure has the advantage of both allowing the legislators to make more accurate forecasts of revenues that will be collected from the tax and, at the same time, taking advantage of higher sales prices, while not overburdening producers when prices are low. The major disadvantage of a hybrid tax structure is that it is the most expensive to enforce because a taxing authority must incur all of the costs associated with both value-based and volume-based severance taxes.

The severance taxes that have been proposed in Pennsylvania are either volume-based taxes or a hybrid tax structure. The earliest proposed taxes, including Governor Rendell's proposal, were hybrid taxes. These include House Bills 325, 2435, and 2438 along with Senate Bills 905, 997, and 1254. With the exception of House Bill 325, all of these bills propose a tax of 5 percent on the wellhead value plus 4.7 cents/MCF extracted. Not coincidentally, this is the same tax rate that is imposed by the West Virginia hybrid severance tax.[4] Pennsylvania House Bill 325 has proposed a higher rate of 8 percent on the wellhead value and 8 cents/MCF extracted.

More recently, several tax bills have been introduced that would apply a volume-based tax. House Bill 1489 was originally a hybrid structured tax when it was introduced, but it has since been amended to be a volume-based tax. Along with this bill, House Bills 2443 and 2579 have proposed a volume-based tax. The biggest variation among these bills is the base rate of tax charged. On the low end, House Bill 2443 would charge an initial base rate of 25 cents/MCF extracted while House Bills 2579 and 1489 would charge a base rate of 30 cents and 35 cents/MCF respectively.

In order to allow the Commonwealth to benefit when fuel prices are high, all of these volume-based severance taxes are adjusted based on an "Index." This Index is determined each year based on the New York Mercantile Exchange Henry Hub settled price on March 31 for the previous 12-month period, as reported by The Wall Street Journal. If 5 percent of the Index is greater than the base rate, then 50 percent of the difference between 5 percent of the Index and the base rate will be added to the base rate for the coming year. In no case will the tax rate fall below the base rate.

Exemptions from Taxation

Most of the Pennsylvania severance tax proposals also contain exemptions. In general, these exemptions are categorized as front-end or back-end exemptions. Front-end exemptions reduce or eliminate the tax in the initial years when the well begins production to account for the upfront costs of establishing the site and drilling the gas. Back-end exemptions reflect the fact that gas wells have a very productive period at the beginning of the life cycle and then will continue to operate for many years with much lower production rates. The back-end exemptions incentivize drillers to continue operating these older, low-producing wells rather than drilling more wells.

A common back-end exemption is known as a "Stripper Well Exemption." The Stripper Well Exemption generally eliminates severance taxes on wells producing less than 60,000 cubic feet of gas per day. All of the severance tax bills introduced in the Pennsylvania House and two of the four bills introduced in the Senate (Senate Bills 905 and 2579) contain a Stripper Well Exemption.

In another common exemption, Pennsylvania legislators generally agree that new taxes should exempt shallow wells in order to exclude many existing, small well owners from the new tax, which is aimed primarily at Marcellus Shale extraction. This type of exemption has led to debate in West Virginia, which currently has a severance tax with an exemption for shallow wells. Several bills currently pending in West Virginia have proposed modifying the definition of a "shallow well" in order to expand the exemption.[5] Another way Pennsylvania could exempt existing gas wells would be to base the tax rate on the year that the well was drilled, such as is done in Montana, although in Montana older wells are taxed at a higher rate.

House Bill 1489 contains an exemption designed to promote employment of Pennsylvania employees. This exemption creates a tax credit for the gas producer of $2,500 for every Pennsylvania job created, up to a maximum of $25 million annually per company. Legislators hope creative exemptions such as this will maximize the local economic growth due to Marcellus Shale.

Industry groups have been lobbying for Pennsylvania to enact front-end exemptions such as those in Texas or Arkansas. Both Texas and Arkansas impose a value-based severance tax on natural gas, with a base rate of 7.5 percent of the wellhead value in Texas[6] and 5 percent in Arkansas.[7] In Texas, natural gas production is taxed at a reduced rate when produced at new wells with higher than average development costs. This exemption is in place until the well has recouped half of the development costs from the reduced rate. The Texas severance tax also includes a reduced rate for low-producing wells, but only when natural gas prices fall below $3.50/MCF. In Arkansas, the severance tax is reduced for shale-type wells, or "high-cost gas" as defined in the Arkansas code, during the first three years of production to help offset development costs. The Arkansas rate is again reduced when production falls below 100,000 cubic feet of gas per day. Despite the industry lobby's call for help in defraying the initial costs of drilling, no Pennsylvania proposed bill to date contains any front-end exemptions. Governor Rendell has indicated that he will veto any severance tax that is not substantially similar to the West Virginia model.

Distribution of Tax Proceeds

Another area of debate within the Pennsylvania legislature is the distribution of severance tax proceeds. Governor Rendell's initial proposal was to put 90 percent of the revenues into the Commonwealth's general fund. Many Democrats and Republicans alike disagree with that plan. These legislators argue that more money should go to specific environmental programs to offset the damage caused by the increased drilling and to local municipalities to cover additional expenses such as road damage and emergency response that will accompany the new industry. This distribution debate will continue to be a hot topic in the coming months.

Next Steps

Pennsylvania Act 46 has guaranteed one thing—the debate will continue on Pennsylvania's natural gas severance tax for at least a few more months. While the Act seems to dispose of the debate over whether to apply a tax at all, plenty of argument remains over the structure, rate, and exemptions of the new tax. One way to predict what Pennsylvania may do is to compare the severance taxes of other relevant states.

Of the other Marcellus Shale states, New York, like Pennsylvania, currently does not have a severance tax on natural gas. New York does, however, have a "production tax," which is a property-type tax assessed each year based on the amount of natural gas produced on the property.[8] Virginia also does not have a state severance tax on natural gas, but it allows counties and cities to levy a value-based tax of up to 1 percent of the fair market value of the gas.[9] As stated above, West Virginia imposes a hybrid severance tax similar to many of the Pennsylvania proposals of 5 percent of the wellhead value and 4.7 cents/MCF extracted. Originally, West Virginia only had a value-based tax, but in 2005, it added the 4.7 cent volume-based tax in order to help correct a deficit in the state's workers' compensation fund.[10]

In other major natural-gas-producing states, Texas and Arkansas, as discussed above, have a value-based tax. Louisiana, on the other hand, applies a volume-based tax rate that is indexed in a similar fashion to the current Pennsylvania volume-based proposals.[11] Historically, this indexed rate in Louisiana has varied from as low as 7 cents/MCF in 1992–93 to as high as 37.3 cents/MCF in 2006–07, following the surge in fuel prices.[12]

The Pennsylvania Senate returned from the summer recess on September 20. This leaves only a few days to hash out a severance tax by the agreed-upon deadline of October 1. To ensure a robust natural gas industry for Pennsylvania, government leaders must balance the imposition of a severance tax with the passage of favorable pooling and zoning laws. It can be expected that debate on the best way to tax the potentially lucrative production of Marcellus Shale natural gas will continue. Check back with Jones Day for updates as this debate continues.