Shale gas – what tax should be applied and when?

The public debate on tax levies to be charged in Poland on shale gas production failed to address some important aspects, among them the reasonableness of introducing new tax regulations at current stage of exploration. This analysis explains why it is unreasonable to enact new tax regulations (to be in effect in 2020) before the beginning of commercial shale gas production.

The government's interest is secured by fiscal revenues

Considering a key role played by foreign companies, the government's interest in potential shale gas production will be secured primarily by fiscal revenues. If domestic businesses are the key players, then it is in national interest to support their development by imposing lower tax rates and thus reducing the fiscal revenues. A clear-cut conflict of interest emerges: the lower tax on production, the higher profit of businesses and lower revenues to the government. And conversely, the higher rate of taxation, the higher revenues to the government and lower profits generated by the companies.

It should be noted that the total tax burden of an enterprise cannot exceed a limit point at which the project breaks even that corporations must consider prior to embarking on any capital project. The limit point denotes the maximum rate of tax that is acceptable to investors, rather than merely a rate at which investors are able to recover the capital employed (that obviously does not guarantee any satisfactory profits).

In other words, this is the maximum rate of taxation at which a company will decide to invest in a project. The higher interest rate above the break even point, the higher “losses” are incurred by the government by conceding some of its revenues to the companies that may generate some extra revenues.

It is impossible to set the break-even point precisely. Minimum rate of taxation that gives “green light” to a project may vary from one enterprise to another.

Nevertheless, the government should make an effort to establish approximate location of the point and propose rates of taxation on that basis.

In line with Laffer Curve mechanism, excessively high rates of tax on gas production may result in discontinuation of exploration projects, as potential gains will not offset the cost and risk of investment activities. In that situation capital investments may go to other countries where tax levies are better aligned to business operations. This was the case of Alberta Province (Canada) which saw a downturn in oil sector activity due to an excessively high tax burden.

The optimal point of the total tax burden varies from one country to another and is different at particular sector development stages, as the investment risk changes with the progress of development. Consequently, if geological conditions are similar in two countries, the country in which gas or oil fields are better appraised and the sector is more developed may afford a higher level of taxation that the country in which extractive industry is under development and preliminary studies have to be made in potentially prospective areas. This is primarily due to a higher business risk that has to be compensated for by lower rates of taxation.

Therefore, in the context of the aforementioned principles, any discussion on whether the proposed total tax and other charges on revenues at a rate equal to 40% are high or not high, is pointless at this stage of sector development. The rate may well prove to be either too low or too high depending on whether it is situated above or below the break even point. This cannot be decided at this stage.

Tax system changes upon appraisal of fields

The existing shale gas exploration projects in Poland bear a high risk of investment so that exploration companies are unable to make even rough estimates of future costs and profits. This, in turn, makes it impossible for the government to determine an optimum rate of tax on production.

The appraisal phase, currently underway in Poland, carries the highest investment risk. It is also the most capital-intensive phase. Oil and gas companies have to allocate considerable funds to the drilling of appraisal wells while being perfectly aware that only some of them, if any, will ever produce gas on a commercial basis. Profits are not generated at appraisal stage.

Increasing revenues are generated as the volume of extracted oil is up with the onset of production phase, while both cost and risk tend to diminish. The tax system should reflect this specific pattern of oil and gas production projects.

In light of the foregoing comments, it should be emphasized that the enacting of regulations on the taxation of unconventional gas production (the Act on Special Hydrocarbon Tax and the amended Act on the Tax on Extraction of Specific Mineables) is premature at this stage of shale gas industry development. Fixing the tax rate at a particular level is not based on any meaningful economic indicators (as they are not determinable at this stage) and must be done in a purely arbitrary way.

The key reason behind the introduction of a special tax system for unconventional gas production was to ensure that the costs are predictable to concession holders. It should be noted, however, that at this stage the “certainty” of the fiscal costs will not necessarily encourage the investors and a sluggish progress of shale gas exploration projects may confirm that assumption. From the investors' perspective, the tax rate is the key taxation aspect, followed by stability/permanence. Fixing the rate of tax on revenues at an inflexible level of approx. 40% (including the special tax on hydrocarbons, tax on production of specific mineables and other existing levies), as foreseen by the bill draft approved by the government, is obviously less advantageous to them than a variable tax rate in the 10 to 30% bracket.

It seems that it would be a better solution to delay the imposition of additional tax burdens to the point when stronger economic factors are known, i.e. until the resources are initially appraised and gas production costs are established. Postponing the imposition of additional taxes is a reasonable solution for both government and exploration companies. The tax system would be based on more firm grounds.

Second – additional charges will be introduced at the time when the companies have already invested significant funds, so that the decision to withdraw would entail higher costs that at preparatory stage, when the decision to abandon exploration comes at no cost. Therefore, by changing the tax system at that stage the government will secure a stronger bargaining position and will afford a higher rate of taxation. The companies will be more willing to incur a higher tax cost than they would be at an initial stage of exploration, as investment risk is lower at that stage. In addition to expertise in geology, they will be familiar with other key business aspects, such as awareness of sector and public agencies' procedures.

Third – a postponement of changes in taxation will not delay generation of revenues to the government, as the proposed changes should take effect prior to the beginning of commercial production. Proponents of immediate tax system changes invoke the current cost uncertainty, but this a weak argument as immediate introduction of new regulations does not preclude their amendment in the future, of which the corporations are perfectly aware.

In the past, many countries with established oil and gas production history have frequently changed the tax on oil and gas produced, especially to accommodate market developments. For example, changes are now being introduced in the United Kingdom where shale gas exploration companies are offered tax incentives, as the existing fiscal framework has been advantageous to conventional gas companies but, as it occurred, not so to shale gas exploration corporations.

Concluding, Poland should refrain from changing its fiscal system until first shale gas is commercially produced. The existing levies on oil and gas sector (licensing fee, mining usufruct fee, royalty, real estate tax, CIT) have been most attractive (as initially intended for the state-owned monopolist POGC). A deferred effective date of tax imposition (to 2020), as proposed by draft Act on the Special Tax on Hydrocarbons, only alleviates negative consequences of the new tax regulations.

At this stage, the Government should explicitly emphasize that any additional levies are to be introduced only if justified by market conditions, i.e. when the companies start to generate profits on oil and gas production. Accordingly, the companies would continue to operate under the existing tax system with only nominal tax levies. Announcing tax system changes and enacting a new law will not bring government's revenues closer nor increase them; instead, it is likely to prompt project abandonment by at least some of the companies, especially if they expected charges lower than those proposed by the Government.

Furthermore, some of the companies would accept the proposed terms and conditions, if they are introduced upon investing huge funds and appraisal of resources in concession areas. This would make project abandonment more costly, making the companies more likely to accept higher fiscal charges.

Flexibility is of the essence

Postponing the tax system changes will not help to make the decision on the rate of tax and on other important tax aspects (taxable revenue, tax due date, collection methods, tax breaks) when preparing the new regulations. Nevertheless, the postponement will help to establish the break-even point.

When attempting to establish an optimal total tax burden the Government should first consider geology (size, quality and accessibility of resources) along with a number of other elements, such as market conditions (including market price of gas from alternative sources, i.e. unconventional gas price in Poland, the price of imported gas, and the demand for gas), Poland's attractiveness in terms of performance of its public institutions and the rule of law, as well as several other aspects that account for overall business environment. When designing new fiscal charges in Poland, decision-makers should take into account charges prevailing in other countries so as to ensure that the proposed tax system is competitive.

Due to the number unknown variables involved, the break-even point can be set at a number of different levels. In the optimistic scenario, if Poland's shale gas resources prove to be really important and easily recoverable, the investors may find attractive government take set at a level of, say, 70%. Under pessimistic scenario, any additional fiscal charge may cause the shale gas to be non-competitive with regard to imported gas. In that case, benefits from energy security enhancements, improved trade balance or additional jobs in the sector should prompt the Government to refrain from imposing any additional taxes.

Some countries were able to generate significant revenues at high rates of tax on petroleum production (Norway, Libya), whilst other were unable to attract investors despite the relatively low fiscal charges (e.g. Russia). This proves that the tax rate should be set as a resultant of several variables.

On introducing a specific tax rate immediately before the stage of commercial production, the Government should establish regular monitoring to check whether the proposed profit sharing ratio is at an optimum level. Should it occur that following the imposition of the additional tax the rate of exploration is getting lower and investors tend to withdraw from gas production projects, the total tax burden should be immediately decreased. On the other hand, if the enterprises report relatively high rates of return (much higher than comparable production projects in other countries), then a higher rate of tax should be considered.

Flexible approach to taxation is beneficial to the government and businesses alike, provided, however, that the governments designing tax systems properly assess attractiveness of the country and investment risks incurred by enterprises at particular stages of oil and gas production.

The abilities to assess investors' potential profit, cost and risk are the key skills to be developed by Polish institutions.

author: Paweł Musiałek, Klub Jagielloński

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