How to make a mess of an energy windfall tax

Sometimes it pays to keep things simple. The proposal to limit the earnings of renewable energy companies in the UK appears to be a mess.

Liz Truss’ government is ideologically opposed to levying anything that appears to be a windfall tax (despite having retained the additional levy on North Sea oil and gas exploration imposed in May). A cap on the income of companies from renewable energy is therefore not referred to as a windfall tax – similar to the one that is being introduced in the EU. And unlike traditional windfall taxes, it’s not an after-the-fact tax on profits.

That’s where the problems start. Perhaps best for the industry as a whole would have been if those with old-style subsidized contracts – which can attract politically problematic windfalls – had voluntarily traded the benefit of sky-high prices now for long-term, fixed-price contracts that offer more security. My colleague Helen Thomas made the same argument last month.

There would have been some complications, but there are clear benefits from lower financing costs over the project lifetime. Analysis by Aurora Energy Research in September put the potential savings for generators from cheaper financing at between £2.5bn and £3.3bn.

That’s not where we ended up. The problem with such a contract change is that it would be difficult to implement for the coming winter. It’s not hard to see how that could be a problem for a government that has shouldered a very heavy bill to help homes and businesses through the cold season and needs to be seen doing something – not least because they it has now demonstrated its fiscal credibility to the markets before the end of the month.

It’s also easy to see how this could lead to a sub-optimal design of a new tax for the industry, whatever it’s called. And a sales cap is anything but ideal.

The first problem with a sales cap is that producers are not necessarily benefiting from high prices at the moment. Many have secured their production for this and next winter. Many of these hedges – particularly those for this winter – will have been taken out at prices well below prevailing spot prices in the markets.

In one situation, the government ignores these safeguards and bases the cap on what producers would theoretically have received. Generators end up out of pocket, but the government collects a handsome amount of revenue. Alternatively, the government is considering hedging, noting that many producers are not actually getting large windfalls on their output this year, and ending up with rather less revenue than expected.

What has really spooked the industry is the potential level of the UK cap – originally rumored to be £50-60 per megawatt-hour if wholesale prices are above £400. The EU has set the upper limit at 180 euros.

A cap of £50-60/MWh might make sense if offered in long-term exchange. As a sales cap, Jefferies analysts called it a “punishment” and distorted both markets and investment incentives.

It is clearly possible to exaggerate the risks to investment by introducing a revenue cap: nobody will have made investment plans on the basis of receiving £300/MWh and up. Below that, there should be a level where it’s possible to cap revenue without compromising the attractiveness of the investment that’s at the heart of net-zero plans. Embarrassingly for the UK government, it is perhaps easiest to assume that the best level is what the EU has chosen and deviate from that.

While a traditional windfall tax on profits could go hand in hand with carve-outs for certain types of investments – as was the case with the North Sea oil and gas levy – the cap on earnings doesn’t offer that kind of nuance.

Ideally, the government would continue to pursue a program to convert old-style renewable energy projects to longer-term fixed-price contracts, even if it’s not immediate. There will be those who don’t want to participate because their projects have shorter remaining life expectancy and aren’t worried about long-term fixation. And the benefits are likely to diminish the longer it takes to organize a switch to long-term fixed-price contracts, since profits are lower when the price is lower. But at least it would avoid a similar windfall problem happening again.

Meanwhile, the renewable energy industry is much more likely to want a classic windfall tax like the oil and gas industry.

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