Petroleum Taxation Contingent on Counter-factual Investment Behaviour.

• Author: Osmundsen, Petter
• Position: Report

1. INTRODUCTION

   Morris Adelman will be remembered primarily for his many contributions to the economics of petroleum supply. In analysing this market he was aware that royalties and taxation played significant roles. In The World Petroleum Market published in 1972 he noted how the ability of host government to levy and change taxes on production income could increase the cost of capital for investors (p. 56), and how high taxation at or near the economic limit could mean that a concessionaire became in effect a hired contractor (p. 218). He also noted how the interaction of the posted price system in the Middle East with the corporate profits tax system in Western Europe produced the phenomenon of widespread downstream losses which caused great concern to the tax authorities. Adelman noted the effects of (high) taxation in producing countries on depletion. In his well-known paper "Mineral Depletion with Special Reference to Petroleum" (Review of Economics and Statistics, February 1990) he highlighted the importance of the potential effects of taxation in slowing (or increasing) depletion rates. He also noted how nationalisation in major producing countries affected depletion rates by abolishing the tax wedge. In another paper "Constraints on the World Oil Monopoly Price" (Resources and Energy, January 1978) he advocated the use of an ad valorem import tax on oil by consuming countries which could, if well-designed, in effect absorb part of OPEC's revenues. Given his general suspicions regarding the effect of taxation on petroleum supply the present paper attempts to clarify recent controversies in this area.

   Government allocate exploration and production rights to petroleum companies on behalf of the nation, acting as the principal with the companies as agents. Capturing revenue for the state is a principal object. Efforts are made to devise a neutral tax system--in other words, one which ensures that the companies will wish to implement all projects profitable on a pre-tax basis and drop all unprofitable ones. This is achieved when the net present value (NPV) after tax is positive if--and only if--the NPV before tax is also positive. Note that this implicitly assumes parity between socioeconomic and commercial profitability. It also presumes symmetric information between oil companies and government.

   While the government seeks to maximise its tax income over time, it must take account of the fact that companies set specific required rates of return for their activities. This can be formalised as a participation constraint. See Osmundsen (2005). A key consideration here is the way companies make their investment decisions. Oil companies, as other companies, apply the traditional NPV method and have relatively substantial rate of return requirements including minimum NPV/I ratios. Tax deductions are treated as other cost elements. See, for example, Brealey et al (2008).

   Depreciation tax shields contribute to project cash flow, but they are not valued separately; they are just folded into project cash flows along with dozens, or hundreds, of other specific inflows and outflows. The project's opportunity cost of capital reflects the average risk of the resulting aggregate.

   As in all principal-agent theory, oil companies may have incentives to report strategically. (1) Where conventional NPV analyses are concerned, the oil companies may have private information on the required rate of return and can in principle achieve an information rent through strategic reporting (excess reporting of the required rate of return). We can also conceive a game over the information rent related to the choice of decision method.

   Where the petroleum sector is concerned, the Norwegian government has developed a fairly extensive administrative system, and civil servants are in close touch with the industry--in part through participation at licence meetings. They gather information on actual decision processes, and this knowledge is supplemented by insights from former company employees. Actual required rates of return and decision methods can also be deduced from an analysis of decisions taken (revealed preferences). Thus, the information problem is limited.

   Taxation is placed in a broader framework as part of the application of principal-agent theory to the petroleum sector. See Osmundsen (2005). We study literature in the field of public sector economics which argues in favour of partial discounted cash flows, where tax-related depreciation has a different discount rate than other cash flows. See, for example, Fane (1987). A typical feature of this literature is that it does not build on empirical facts, but merely assumes that companies regard tax-related depreciation as riskless. We compare this with empirical work on petroleum taxation, including Johnston (2008). Furthermore, we compare it with studies of the actual investment behaviour by companies, including Summers (1987), Boston Consulting Group (2007) and Brealey et al (2008). We look at the effect of tax systems on various components of company decisions. The question is not only whether to invest, but also how the investment is dimensioned. See Smith (2014) and Osmundsen (2013). We analyse implications of different types of tax-related depreciation schemes by using model oil and gas fields.

2. TAX DESIGN

   Governments seek to maximise their tax income over time, but must take account of the fact that companies set specific required rates of return for their activities. This can be formalised as a participation constraint. Whereas the petroleum resources are immobile, the competent oil companies are highly mobile. They typically have projects in many countries and there is competition over investments and other scarce inputs. A key consideration here is the way companies make their investment decisions. They apply the traditional NPV method and have relatively substantial rate of return requirements. Tax deductions are treated in the same way as other cash flow elements. This must be taken into account if the aim is a neutral tax system--in other words, one which does not reduce value creation by distorting company investment behaviour.

   Cash flow tax is a reference case for a non-distorting tax system. It reduces the size of cash flows and will accordingly cause no distortion to investment decisions--a project which has a positive/negative NPV before tax will also have a positive/negative NPV after tax. Tax-related depreciation is a recurring issue in petroleum tax design. Permitting investment costs to be deducted in the year they are incurred will be in accordance with a cash flow tax. This is the case for exploration costs in both the Norwegian and British petroleum tax regimes. Tax-related depreciation is spread over several years in many countries. In Norway, for example, the maximum depreciation rate for development costs is 16.67 per cent per year. The NPV of tax depreciation is accordingly lower than the development cost, and the investment incentives may be too weak--underinvestment is likely.

   To compensate for the NPV loss from delayed tax depreciation in Norway's petroleum tax system, a tax-free allowance or uplift is granted at a certain percentage per annum over a given number of years. This uplift is computed on the basis of the original capitalised cost of offshore production installations. A similar system applies in Australia, for example. Investment neutrality is maintained when the uplift has been set so that it becomes a matter of indifference to the oil companies whether investment can be deducted in the year it is made or they receive the sum of tax deductions over a given number of years plus uplift--provided they are certain to be in a tax paying position. The uplift thereby compensates for the NPV loss of delayed tax depreciation. When setting the uplift, the government accordingly needs to ascertain the rate of return required by the companies (the discount factor). This has become a recurrent topic for debate between the Norwegian government and the companies, especially after a controversial change to the uplift for Special Tax in May 2013 when its annual rate was cut from 7.5 per cent over four years to 5.5 per cent also over four years. In contrast the UK Government has just introduced an uplift allowance for Supplementary Charge at the rate of 62.5% in an effort to stimulate investment following the oil price collapse.

   Norway's Ministry of Finance has assumed that the companies use partial discounted cash flow analysis and, if they utilise a simpler method which may yield a different project assessment, this will be of little significance for the Ministry. It departs here from principal-agent theory, which precisely seeks to clarify and build on the actual decision criteria used by the companies. This poses challenges in that socioeconomically profitable projects might now be dropped. We should add here that this comes up at a very unfortunate time, the oil companies are in a period of capital rationing and critical upgrades are required on a number of the mature fields on the Norwegian continental shelf (NCS) if large volumes of oil are not to be lost (Osmundsen 2013). The socioeconomic losses could be very substantial.

   Assuming counter-factual behaviour in the field of regulation and taxation is unusual. Under the previous government, the Ministry (2013) claimed that the oil companies apply changing and irrational decision criteria, and that the tax system must therefore build on theory. When reality does not accord with theory, it must yield. The terrain must be compelled to agree with the map.

   The Ministry bases its views about petroleum taxation and partial discounted cash flows on financial theory about value additivity. This states that the value of an investment project can be calculated in principle as the sum of the values of partial discounted cash flows, each discounted by an associated risk-adjusted requirement...