The way the UK taxes oil companies needs to change

Oil and gas production is taxed differently from the rest of the UK economy and for good reasons. BP, for example extracts a national, non-renewable resource and regularly makes annual profits in the billions; your local bakery doesn’t.

How and how much we tax oil and gas companies has the potential to directly affect how much we, as the public, benefit. It also impacts how the burdens of oil extraction – such as environmental degradation and climate breakdown – are distributed between us and them.

In their first budget, Labour already made changes to the tax regime for oil and gas, for example by bringing the headline tax rate to 78%. Now, as the Government launches its planned oil and gas consultations, it has an open opportunity to overhaul our flawed tax system and to deliver on its Green Prosperity Plan and ensure a just transition away from fossil fuels. 

Following the new government’s first budget, we zoom out to take a broader look at the debates about the future of North Sea taxation – and why Labour should go beyond tweaks to the windfall tax.

Radical tax cuts to sustain an industry

The UK’s oil and gas production has declined since the turn of the millennium. As reserves depleted, the opportunities for new developments became smaller and more expensive, driving decline and changing business models. Concerned about the industry's challenges, the coalition government’s energy secretary, Ed Davey, commissioned a retired oil magnate to review the UK’s and industry’s options.

The review’s recommendations put a new legal objective at the heart of how the UK governs its oil and gas resources: maximising economic recovery – a mission to recover all resources where the benefits outweigh the costs. Spurred on by intense industry lobbying, the UK launched a “radical” package to deliver this new objective, with headline tax rates dropping dramatically in 2015-16 (Graph 1). Soon, the Chancellor could boast of presiding over “one of the most competitive tax regimes for oil and gas in the world”.

The belief was that lower taxes for oil and gas developments – and more expansive tax breaks – would encourage companies to keep producing from the North Sea, even as the largest, most profitable fields were depleted. The hope was that by incentivising maximum extraction, the UK would prosper, and a focus was placed on company profits and production secured, which were seen as the primary benefit to the economy from the industry, not its tax returns. The oil and gas operators were in the driving seat, “the benefits” and “the costs” of maximising economic recovery defined on their terms and in their interests.

The energy price crisis: a moment of reckoning

However, the fragility of this settlement was exposed when global energy prices soared following Russia’s invasion of Ukraine in 2022. Oil prices – and company profits – skyrocketed, while millions of UK households faced crippling fuel poverty as energy bills surged. 

Each rise in the energy price cap was met with record earnings for the sector, reinforcing the case for action. Chancellor Rishi Sunak responded by introducing the Energy Profits Levy (EPL), commonly referred to as the “windfall tax”, which has since funnelled over £6 billion from oil and gas companies to help offset spiralling household energy bills. 

What is wrong with the Windfall Tax?

Yet Sunak’s response, like George Osborne’s Fair Fuel Stabiliser a decade earlier, was a short-term fix rather than a solution to the deeper, structural problems with the UK’s oil and gas tax regime. The Energy Profits Levy has three main flaws:

1. It missed the windfall. Late implementation of the windfall tax meant companies pocketed the lion's share. In 2022, companies paid only £1.8 billion in windfall tax and walked away with over £32 billion in post-tax profit¹. Once again, the windfalls got away. 
2. Investment allowances generated useless loopholes. The “indefensibly generous” investment allowance protected existing investments, reducing tax revenue by billions of pounds, rather than incentivising companies to increase investment, which was its stated aim. As a result, companies developing fields that would have proceeded regardless received billions of pounds of additional tax relief for no good reason – benefiting oil companies such as Equinor, which made £62 billion in profits globally in 2022, at the expense of the UK and the climate. 
3. It sent the wrong signal about the energy transition. Oil and gas companies are failing to invest in the energy transition. The EPL didn’t help, creating an imbalance in tax relief for oil companies that might invest in renewables, with reliefs for investments in oil that are over three times as generous as wind.

Labour’s plans to fix these flaws

Labour is now the custodian of this flawed tax regime, but as they will have found out over the past months, they must fight hard if they are to reform it. The UK oil and gas industry, for whom tax strategy has become a defining focus in recent years, is not afraid of using the threat of job losses as a powerful campaign tool. While declining employment in the industry is one of the UK’s major transition challenges, the oil and gas industry has a long history of protecting its shareholders over its workforce and some of the wilder claims need to be taken with a huge pinch of salt. 

Last month, Labour fulfilled its manifesto commitment to raise the headline tax rate for oil and gas to 78%, aligning it with neighbouring Norway's, while also reducing some investment allowances. Rachel Reeve's changes to the investment allowances represent a more limited interpretation of its promise, and alongside reaffirming a tax consultation on responding to price shocks after the EPL ends that was initially proposed by their predecessors, this appears to have eased some of the tensions with the industry.

That Labour is looking to learn from Norway is understandable; the UK's tax system fails to capture windfalls or generate the benefits seen in Norway, where oil companies consistently pay much higher taxes. For example, in 2018, Norway taxed oil companies at 10 times the rate of the UK. Even with the introduction of the windfall tax, Norwegian companies paid five times more tax per barrel than their UK counterparts and in 2022², the effective tax rate in Norway was still four times that of the UK³.

But while these comparisons with Norway do underscore a point about who benefits from UK oil and gas, the UK’s geology means it is no longer the major petro-state Norway is today. The real problem isn’t just missed windfalls – the UK’s declining oil industry is unlikely to become a significant tax contributor again, except during global crises. The mature nature of the basin also means that the headline tax rate would need to drop far below what would be politically palatable for the UK to be a competitive place to invest in oil and gas going forward.

The real policy question: what role should oil companies play in the transition?

Labour’s critical question isn’t just about taxes – it’s about energy policy. Should oil companies play a central role in the UK’s energy transition? If they are to be partners, allowing them to retain more profits to reinvest in Labour’s clean energy mission might make sense. Labour has announced (or recommitted to) measures such as a subsidy for platform decarbonisation (£109 for every £100 spent) and tax breaks for reusing old oil infrastructure for carbon dioxide storage - which suggests that it is warm to this scenario.

But evidence suggests such a strategy is unlikely to succeed. During the energy crisis, companies prioritised shareholder dividends and buybacks over investments in green energy. BP and Shell, which made headline promises to invest in renewable energy, have quietly backed away from these commitments.

This reflects a broader trend: just 7 out of the UK’s 87 offshore oil and gas companies plan to invest anything in renewables, CCUS or hydrogen by 2030. The commitments to decarbonise oil and gas production made before COP26 have delivered barely any projects, and the reuse of old infrastructure for new carbon dioxide storage is relatively uncommon; meaning that a few companies will pocket huge public subsidies while the UK’s transition will have barely moved.

Tax incentives might help at the margins, but policymakers need to accept that generally, the sector will not, cannot, and should not, reinvent itself.

To deliver its mission, Labour needs to overhaul the system

The past year of persistent campaigning against the windfall tax by industry executives understandably generated nerves among the workforce, who are not seeing the green jobs created and worry about declining oil and gas investment. But like the general public, the offshore energy workforce overwhelmingly backs the UK taxing oil and gas companies fairly. 

So, as the Department for Energy Security and Net Zero prepares again to review the North Sea’s future, the Treasury’s planned tax consultation offers an opportunity for alignment. Labour must overhaul the oil and gas tax system to support its Green Prosperity Plan and manage the decline of oil and gas in a way that delivers a just transition. To achieve this, energy and climate goals should drive tax policy – not vice versa. 

The government needs to embrace the reality that if oil companies can’t and won’t transform, their only option is to no longer support the pursuit of growth for the sector, and it should design the fiscal regime accordingly. 

Instead, the government should strike a compromise between the interests of shrinking North Sea businesses seeking a return to their shareholders, which will have implications for workers and communities that have benefited from the sector, and the general public, who should not shoulder the costs of cleaning up the toxic legacy of atmospheric emissions and oily platforms at sea the industry has left behind. 

Here’s what such a compromise might look like: 

First, plans to reduce the baseline tax rate back to George Osbourne’s “radical” rates should be shelved. The tax rate should reflect the fact that these companies are profiting from extracting a non-renewable resource and that companies responsible for climate breakdown should contribute their fair share to the costs of climate damage and ensuring a just transition. However, there are limits to how much the UK’s declining industry can be squeezed to pay for these costs. Gone are the days where large payments are likely to flow from the North Sea and shrinking North Sea businesses. Realistically, the job today is to hospice the end of the oil industry, rather than expect major contributions to the transition through tax revenue. 

Second – and perhaps most obviously given previous cross-party consensus – Jeremy Hunt’s 2023 fiscal review rightly concluded that the UK needs a permanent mechanism on top of its baseline tax rate to ensure future windfalls don’t slip through the cracks and to break the UK out of a cyclical hiking and slashing of headline tax rates. 

Third, in the first instance, new oil and gas developments – which are incompatible with the UK’s climate commitments – should not be approved. And they certainly should not receive tax relief: these reliefs should be scrapped. Additionally, Labour committed in its manifesto to “manage our existing fields for the entirety of their lifespan”, a position challenging to square with climate science. Doing this will require additional investment in existing fields, something the industry will only do if they receive substantial tax breaks for it. Set against increased public climate concerns and industry profiteering, this may be hard to sell politically.

Fourth, careful thought needs to be given to the narrow ways in which oil and gas companies could productively contribute to the energy transition, and tax breaks may be appropriate to encourage action in these areas. The existing system is riddled with loopholes designed to support maximising economic recovery and – to a lesser extent – net zero, and the evidence base for their effectiveness is limited. Tidying up the system to deliver the new government’s energy transition goals is a clear priority.

But the hard reality is that, at the moment, the vast majority of oil and gas companies are commercially disinterested in the energy transition – despite all the glossy rebrands and expensive adverts in the political papers. And so the justification for incentivising them to do so seems practically and morally dubious. However, there may be some areas for compromise. Reliefs, such as those for decommissioning, could be conditional, ensuring they create jobs and benefit the UK economy. While this may seem at odds with the polluter pays principle, ensuring that decommissioning creates jobs and delivers positive benefits for the marine environment is arguably an acceptable compromise to ensure decommissioning takes place and delivers maximum public benefit. 

So, in the face of intense industry lobbying aimed at securing the best outcome for boardrooms and shareholders, the Treasury shouldn’t just hold its nerve; it should work with DESNZ to design a new fiscal regime, one that acknowledges the days of a dominant industry maximising extraction are behind us, and that serves the government’s energy and policy goals, and the broader public.

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