Windfall Taxes Are Politically Appealing, Especially If You Don’t Plan To Be Around When The Resulting Underinvestment Appears

Governments love windfall taxes. They offer a way to generate revenue from industries that are experiencing sudden, unexpected surges in profits. In theory, this seems like a good idea and politically they are well received as they can and have been described as sticking it to the big guys. Entire political campaigns have succeeded on that same general premise. History though continues to remind us that windfall taxes are a double-edged sword.

The recent wave of windfall tax announcements in Europe is a case in point. Several countries, including Italy and the United Kingdom, have implemented windfall taxes on energy companies due to soaring energy prices. Italy approved a 50% windfall tax on the extra income of energy companies as part of measures aimed at addressing rising energy costs. In May 2022, the UK government announced a windfall tax on oil and gas companies. This was partly to protect consumers, but also to balance budgets amid an economic downturn. The taxes on oil and gas companies increased from 25% to 35%.

The oil and gas sector is a natural target for windfall taxes, given the extreme volatility and current unpopularity. The ironic thing about targeting oil and gas excess profits though is that these extreme periods are how the sector returns profits at all. Multiple studies have shown that oil and gas companies have largely returned their cost of capital over the long run, resulting in one of the poorer returns on equity of a major sector. This isn’t to say that lots of operating teams haven’t proved they can consistently outperform, it is just the nature of any commodity business to return close to its cost of capital over an extended period. Interestingly we may be entering a golden age of returns for commodity businesses, as ESG factors create the barriers to entry that finally allow incumbents to earn outsized returns, but that is for another article. As of now, the returns for the sector haven’t structurally changed, and herein lies the problem. If oil and gas companies require periods of surging profits to re-invest in supply, to provide the energy we all use, then preventing that cycle is going to make spikes more extreme.

Windfall taxes discourage investment and innovation in the targeted industries, which are the exact industries where people are typically upset about the supply shortage. If companies know that any success will be met with a hefty tax bill, they will be less likely to take risks and invest. Total, Shell, and Equinor have already said they are re-evaluating investment in Europe after these latest tax increases. Ironically, this is exactly what happened in the UK in the 1980s, when the government imposed a windfall tax on oil companies. The tax was meant to recoup some of the profits made during the North Sea oil boom. However, it ended up discouraging investment in the industry and ultimately resulted in less oil being produced.

One of the additional risks of the current wave of taxes is it may delay renewable investment. Oil and gas companies are some of the largest investors in renewables and gas remains the best fuel for competing with baseload coal. Nuclear is arguably better but for whatever reason the world continues to shut down clean operating nuclear plants. Even Shell Ventures is listed as one of the most active investors in the renewable energy ecosystem. Some environmentalists did flag that the Italian taxes may result in reduced renewables investment and grid stability risks but beyond that, there hasn’t been much of a discussion on renewables impacts. Windfall taxes are also currently being used to subsidize energy costs, which prevents a large consumption response. Effectively everyone is moving forward with plans where people don’t have to pay for the true cost of energy, meaning they won’t reduce their consumption, and companies that also invest in renewables have fewer dollars. Both seem very bad for the environment. There are always cries to tax oil and gas out of existence but then it just gets produced in regions with less stringent environmental rules. This happens again and again.

Windfall taxes can often do more harm than good, but it takes time to play out, and politicians can usually move on to the next thing by the time that occurs. It’s also difficult for reasonable politicians to argue with the current taxes as you have to spend a lot of time making it clear that you believe in protecting the environment, and you want to reduce living costs, but that you also believe in cause and effect.