At least one part of the Scottish economy appears to have a solid piece of research backed by recommendations regarding its future whether or not there is a ‘Yes’ vote in a few weeks. Jeremy Cresswell examines the “Maximising the Value Added” report on oil and gas.
They had only a few months in which to deliver and perhaps the landscape was complicated to some extent by the Wood Report, which was published while the members of Scotland’s Independent Expert Commission on Oil and Gas did their work.
Predictably, there is a strong overlap between what Wood delivered and the “Maximising the Value Added” report commissioned by the Scottish Government and which has just been published.
However, there are a number of major differences, the most obvious being that the Commission had a fiscal remit whereas the Wood team was not allowed to go anywhere near the taxation side of; the UK industry.
Another is that the Scottish Government commissioned this report to inform the debate in advance of the referendum, with an emphasis on ensuring the sustainable future of the UKCS whilst also helping to guide future potential energy policy in the event of a “Yes” vote.
Further, there was a need to get a grip on what the overall value of the UK oil and gas industry actually is. It goes beyond the MER (maximising economic recovery) mantra of the Wood Review by considering total value added (TVA) generated by the sector for the economy as a whole.
The Commission rightly points to the still more or less absence of a real understanding of what overall value is generated by the production of hydrocarbons from the UKCS to the wider economy.
Supply chain has always been secondary; indeed in the early years of the North Sea its development was very much as an afterthought as former Offshore Supplies Office supremo Norman Smith warns in his book The Sea of Lost Opportunity, which is based on work be carried out for his PhD at Aberdeen University a few years back.
As the Commission says in its report: “Without this clear understanding it is impossible to judge what is ‘economic’ in assessing what resources are recoverable. It is also impossible to design policies which will garner the vital future investment and maximise the potential value of the basin.”
Driving the point home further it says: “A dual approach for delivering MER and generating maximum TVA must set the agenda for government, the new (North Sea) regulator and industry, to ensure that we, as the UK or as independent Scottish and rest of UK jurisdictions, take action quickly to maximise the full potential of the UKCS.
Oh, and there’s something else; whilst DECC and perhaps wider UK government seems more focused on the low end of the remaining potential recoverable reserves estimate for the UKCS … roughly 10-24billion barrels oil equivalent, the Commission is clear; set the sights high, not in a low almost apologetic manner.
This was unquestionably a tough brief for anyone, but the slightly unusual composition of the Commission … North Sea subsea veteran member of the Scottish Government’s Energy Advisory Board, Dick Winchester, renowned petroleum economist Alex Kemp; entrepreneur Melfort Campbell; and Rita Marcella, dean of Aberdeen Business School – The Robert Gordon University … lends a distinctive edge to approach used and therefore lends a freshness to many of the recommendations.
But let us be clear, many of the issues analysed by the team are not new and have been under various industry and UK government microscopes since at least 1993 … dawn of a massive cost-cutting drive known as CRINE and related CRINE Network, which did immense damage, albeit this was recognised only in retrospect.
Critical issues
A veritable stack of critical issues were examined against a background of:
• Falling production levels and production efficiency;
• Development and operating costs at record high levels;
• Exploration activity at a near 50 year low;
• Average salaries continuing to rise (increasing by 35-40% since 2006) putting pressure on companies’ wage bills; and
• The number of people needed to produce a barrel of oil has risen from 18 in 2006 to 45 in 2012
• A tax regime that is no longer fit for purpose
They included stewardship of the UKCS; the fiscal regime; governance and licensing; health, safety and environment; decommissioning; technology and innovation; skills and what is described as “transition” … the ‘what if there is a yes vote aspect?’.
Fiscal
Because it is so novel – examination of the fiscal climate in an holistic context – we have chosen to concentrate on this more than any other core topic.
North Sea taxation is a major bugbear and astonishingly complex. And obviously it is Prof Kemp’s thinking that colour’s the Commission’s collective view.
In summary, the view is that UK’s offshore fiscal regime should set a stable and internationally competitive investment environment, allowing maximum long-term value to be achieved.
“Stability, predictability and international competitiveness should be the key principles underpinning the fiscal regime, facilitating the delivery of long-term investment to Maximise Economic Recovery (MER) and maximise the generation of TVA over the life of the province,” says the report.
“Alongside this, the key objectives must be to collect a fair share of the economic rents for the state, while encouraging investment in exploration, development and production. However, the current system has become very complex in the way that it targets these twin objectives.”
It is pointed out that, since the millennium, a relatively short period in the life of a major petroleum province, the UKCS has witnessed three major tax increases.
“All of these took the industry by surprise and were followed by the gradual introduction of several field allowances for the Supplementary Charge and a range of other changes. Investors are as a result very conscious of the instability and unpredictability of the regime.”
The Commission notes that the various field allowances are designed to encourage investment in new fields and have made a significant positive contribution.
However it correctly warns: “At the time when investors are appraising projects, it is often unclear whether a field allowance will be available for a specific project.
“Negotiations with government often take place on a case by case basis and have uncertain outcomes. This does not facilitate swift decision-making or adequate transparency for investors.
“The result is a highly complex offshore tax system. For mature fields developed prior to March 1993 the headline tax rate is 81%, with Petroleum Revenue Tax (PRT) being charged at 50% on those fields.
For fields developed after 1993, the headline rate is 62%, with Corporation Tax (CT) at 30%, and Supplementary Charge (SC) at 32%.”
Furthermore, the report points out that effective rates are often significantly lower because of the application of field allowances. However, it tends to be the headline rates which attract greatest attention from potential investors.
While oil prices have increased substantially over the last decade, so too has there been rapid cost inflation in the sector. With the average size of discovery declining and a prevalence of costly HP/HT, heavy oil, and tight gas fields the investment environment has become more challenging.
“Against this background, there is a clear need to align the taxation system to the current and emerging environment. This requires a scheme which ensures, not only that projects which are economic before tax remain commercially acceptable after tax, but that licensees contemplating long-term investments can be confident that their tax liabilities will be reasonably predictable,” says the report.
“The system should incorporate an inherent and appropriate flexibility in response to external factors, particularly oil and gas price fluctuations and cost changes. This requires the system of allowances to be responsive to such changes.”
The Commission suggests that, in designing the structure for the longer term it may also be appropriate for the relationship between headline tax rates and allowances to be reconsidered.
“In this context it is important to recognise that the great majority of future fields are likely to receive a field allowance, albeit that this cannot be predicted with certainty. This prompts the suggestion that lower tax rates with modified allowances could incentivise new developments whilst producing a simpler system.”
In short and laudably, the Commission says government “must seek to ensure international competitiveness, stability and predictability” that is “appropriate” to the maturing environment of the UKCS and the competing investment environment globally.
“The fiscal regime and policy approach must serve the purpose of creating and reinforcing the positive investment sentiment; any changes to the fiscal regime should be credible for the medium and long term, not only for short term purposes and set in light of achieving maximum TVA.
“The simplification of the UKCS fiscal regime must be a key objective for government in the long-term. A number of specific and targeted improvements to the fiscal regime are recommended.”
The other critical issues and their key recommendations
Stewardship
The Commission states that a road map “must” be established quickly for the future of the UKCS, ensuring the implementation of a clear strategy to maximise TVA generation for the nation.
It warns that government and the new industry regulator must be proactive in tackling the impediments to sustained investment, creating a positive sentiment for attracting investment and facilitating its enactment, implementation and embodiment.
And it says that government must play a proactive role in developing the capability and competitiveness of the supply chain with advice and support from the new regulator.
Regulation: Governance and Licensing
The over-arching strategy of MER must be implemented by the new regulator, inclusive of the whole industry, and viewed in light of the ultimate goal of achieving maximum TVA.
The licensing regime must aim to achieve ambitious targets for MER as well as the higher aspiration of maximum TVA.
The new regulator must have a formal right of consultation on fiscal or regulatory issue which could have an impact on investment or production in the UKCS.
Licence terms must be investigated as a means of ensuring greater certainty for operators investing in the UKCS, through incorporating a commitment to meaningful consultation with the regulator and industry on any regulatory or fiscal changes and through formally placing MER and TVA as central to those considerations.
Regulation: Health, safety and Environment
The new regulator in its stewardship role must in no way diminish the health, safety and environmental regulation of the UKCS and must build on the aim of making the UKCS the safest place to explore for and produce oil and gas worldwide.
A single, strong, well-resourced and informed regulatory regime for health, safety and for environmental protection of the UKCS must be established with oversight of all relevant duties, in line with the EU directive.
The regulatory solution for health, safety and environmental protection, must be consistent with emergency response arrangements and the statutory requirements of the EU Offshore Safety Directive.
Decommissioning
The new regulator must have the authority to delay, refuse or amend a decommissioning application where assets have the ability to continue making an economic contribution.
Industry, supported by government, must develop a clear strategy for the investment in the development of new technology and capability to ensure the UK supply chain is able to optimise the TVA from future expenditure on decommissioning.
Government must give further consideration to whether it may be appropriate for selected parts of UKCS oil and gas structures to be left in place and used for other environmentally advantageous purposes.
Technology and Innovation
Government must be the catalyst for investment by the indigenous supply chain through the establishment of R&D and innovation demonstration programmes where optimal national benefit can be obtained.
In support of TVA, government must expand investment in R&D in oil and gas both directly and through centres of excellence that can facilitate collaboration between operators, the supply chain and government in relation to critical technology needs.
Processes targeting improved technology testing are needed to reduce the “time to market” of new technologies.
Government and industry must work in partnership to improve the international reputation, competitiveness and export record of the indigenous supply chain.
Skills
As a priority, government must use its levers to counter the impact of long-term industry under-investment in skills, and the impact on the inflation of wages.
The regulator must act as a catalyst for future investment in skills development from both industry and government, through stewardship, funding, licensing and regulation.
Industry in the UKCS must work with academia to establish excellent technical and graduate programmes with the goal of establishing a world class generation of new professionals.
Transition
And so to the “what if there is a ‘Yes’ vote” bit where the Commission’s view is clear.
It says that, in relation to any regulatory or fiscal regime change within the UKCS, the aspiration should be for predictability, visibility and continuity over the short-term, minimum disruption in the medium term and clarity for the long-term, with the aim of encouraging, not impeding, investment in the province.
In the event of a Yes vote:
• Governments must facilitate a swift and transparent boundary determination to ensure certainty for industry;
• The new regulator must operate within a single regulatory framework with dual government policies;
• Both governments must adopt a collaborative approach with regards to the operation of the fiscal regime, with a view to maximising synergies, minimising compliance costs and a clear focus on providing clarity and certainty to the industry; and
• A single regulatory regime for health, safety and emergency Response with dual government policy control is preferred, providing clarity and reducing transitional uncertainties in order to maintain continuity and to minimise the compliance costs for government and industry.
A huge amount of ground is covered in this study and the overwhelming message that everyone should draw from it is simple: the opportunity is massive, but it can only be fully realised if the sights are set high, that government sets out a fit for purpose regime … and that means more than merely fiscal … and that industry and government get their proverbial finger out.
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