While the North Sea is far from being on its last legs, the collapse in the price of oil and the high cost of running ageing infrastructure does mean that production is becoming uneconomic in an increasing number of fields. This has brought decommissioning activity into sharp focus, for upstream producers as well as the supply chain. Similarly, the subject of decommissioning tax relief has attracted much press coverage in recent months.
The total quantum of the decommissioning liability facing UK continental shelf producers could, based on recent assessments, exceed £50bn. The substantial cost of decommissioning presents a significant issue, and opportunity, for the industry.
Technological advancement, experiential learning and contractual innovation could be some of the factors that enable the overall cost to be reduced, and there is a considerable prize on offer for those that can unlock savings. The UK taxpayer has an undeniable interest in this as well, given that the tax relief associated with decommissioning expenditure could be anywhere between 40% and 55% of the overall cost.
It is worth focusing, for a moment, on why tax relief is given for decommissioning expenditure at all. Businesses pay tax on their profits, that is income minus costs directly incurred in generating that income. Oil producers are no different. Indeed, ever since the specific North Sea tax regime was introduced in 1975, it has been a design feature that tax relief would be given for decommissioning costs. Investment decisions have therefore been made over the past 40 years on the expectation that the tax liability for the field in question will be based on the profits earned, taking account of decommissioning expenditure.
The notion that the taxpayer has to meet a proportion of the impending decommissioning bill is a function of the time at which tax relief is given for decommissioning costs. Despite the fact producers are obliged to build up a provision in their books for decommissioning costs during the life of the field, no tax relief is given when the provision is created. Instead, the tax regime provides that relief is given when the costs are actually incurred. The result is that HM Treasury collects tax during the life of the field on a measure of profits that is bigger than the accounting profit, only to give some of that tax back when the decommissioning costs are ultimately incurred.
Not all countries defer relief for decommissioning costs until the end of field life in this way. The Netherlands, for example, gives relief when the provision is made during the life of the field. The taxpayer does not, in that case, carry the appearance of bearing a share of the decommissioning undertaken at the end of field life. The flip side is that the authorities collect less tax during the productive life of the field. One can debate the relative merits of the two systems; certainly the UK method does not risk giving the decommissioning relief twice, as could happen in the Netherlands if the producer gets into financial difficulty after creating the decommissioning provision but before discharging its obligations.
Decommissioning tax relief is thus a necessary and integral part of the North Sea tax regime, and isn’t any kind of ‘subsidy’ towards the producing companies’ decommissioning costs.
Nonetheless, it remains a simple fact that reducing the cost of decommissioning is in the interests of oil companies and taxpayers alike. Within the existing framework of regulation that sets out minimum standards for decommissioning activity, industry may be able to identify savings and efficiencies. The Oil and Gas Authority has also demonstrated a willingness to intervene, attempting to reduce cost through collaboration – the recently announced well abandonment pilot scheme is evidence of this. However, it must also be recognised that a substantial part of the structural cost of decommissioning activity is driven by compliance with the OSPAR convention. The convention was last updated in 1998 and, if the forecast cost of decommissioning is to be materially reduced, it may be necessary to look again at the convention and consider whether the principles underlying it remain valid today.
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