Should you be worried about energy windfall tax proposals?

Calls have been growing for the government to impose a windfall tax on UK oil and gas producers to help ease the cost of living crisis. According to the Financial Times, Rishi Sunak may even go further and impose a windfall tax on more than £10bn of “excess” profits by electricity generators, including wind farm operators as well as hydrocarbon producers.

Such a tax would go well beyond initial proposals, and is likely to have a huge impact on the UK energy sector. While it might be popular politically, analysts have warned that a windfall tax could hurt investment and the UK’s international business reputation.

Unsurprisingly, the market has reacted pretty negatively to speculation that power generators such as SSE (LSE: SSE), Drax Group (LSE: DRX), Centrica (LSE: CNA), Greencoat Wind (LSE: UKW) and others might be dragged into the tax net. These companies have already laid out big spending plans for the next few years to help the UK meet its climate targets. Today’s windfall profits will help them meet these capital spending obligations; they won’t if they’re confiscated.

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How will a windfall tax hit corporate profits?

At this point, it’s hard to say what, if any, effect a new tax will have on the sector. The Labour Party estimates that a tax on North Sea oil producers would raise £2bn. Greenpeace UK claims the sector will earn windfall profits of £11.6bn this year, suggesting a tax rate of around 17%. A similar take on the £10bn of estimated excess profits of electricity generators suggests a bill of £1.7bn for the sector.

Offshore Energies UK (OEUK) has already estimated that UK oil and gas operators will pay £7.8bn in tax this year, a 20-fold increase in 12 months.

A one-off charge is likely to have the biggest effect on power generator Drax. According to Citi analysts it is “one of the most operationally geared to a fall in commodity prices and/or political intervention in the power sector.” Drax is the UK’s biggest producer of renewable power by output, although it was recently asked by the government to fire up some of its legacy coal power plants to “stabilise the power system during periods of stress”.

Last year adjusted earnings totalled £398m. This year management expects Drax to earn between £540m and £606m. Most green energy companies receive subsidies from the government to help fund the cost of developing renewable projects. These agreements generally fix the price these businesses can charge consumers, with any upside going back to the government.

Drax operates under a different agreement. It benefits from so-called “renewable obligation certificates,” which allow it to keep any upside. This is another reason the firm could be more exposed than most to a windfall tax.

It is also developing carbon capture technology in an effort to generate large-scale “negative emissions”. This year’s outsize profits will help the company fund these plans (carbon capture is notoriously expensive and complex to implement), but if they’re taken away, the company will have to find another source of cash. That could mean more debt or lower shareholder returns.

Of course, we won’t know which corporations will be hit the hardest until details of the plan are announced. Susannah Streeter at Hargreaves Lansdown believes that any windfall tax would be “linked to the amount of cash poured into ESG initiatives to power the energy transition” and “measures taken by companies to ease the burden of high bills for cash strapped customers”.

That indicates that businesses such as SSE, which is investing £12.5bn over the next five years to accelerate its net zero strategy, should get off relatively lightly (there’s also an argument to be made here that Drax could escape the worst as well as a result of its investments).

Big Oil could be sheltered from a one-off levy

There are bigger questions around how the tax would work in practice. Big oil companies such as Shell (LSE: SHEL) and BP (LSE: BP) are making vast profits, but mostly outside of the UK.

Shell paid no tax on its UK oil and gas production last year even though it earned $21bn in net income overall. BP expects to pay £1bn tax on its North Sea profits this year, while analysts are predicting an overall net income of £16bn, an equivalent tax rate of 6.3%. But international earnings would be very difficult to tax.

So how should investors react to this latest threat? The best solution may be to do nothing – yet. As the US investor Peter Lynch once said, “far more money has been lost by investors preparing for corrections, or trying to anticipate corrections, than has been lost in corrections themselves.”

We don’t know what the government will propose, nor do we know if it will actually go ahead with it. Indeed, the backlash from business has already been fierce, and nothing concrete has been proposed.

Moreover, any tax will only be on a percentage of profits. Unless the tax rate is 100% (which seems unlikely) companies will still earn a windfall from high energy prices. And as the government is working hard to encourage investment in renewable energy, there’s bound to be some loopholes in any proposed regime.

Ultimately, a windfall tax is unlikely to hit the long-term outlook for green organisations such as Greencoat UK Wind, which is one of the largest wind energy investors in the UK. A one-off tax is also unlikely to hurt Shell and BP significantly considering their international footprints.

On the other hand, North Sea producers such as Harbour Energy (LSE: HBR) seem more exposed to a UK producer tax, as does Drax, considering its position in the country’s electricity market.

But whatever course of action the government decides to take, it’s unlikely to significantly alter the long-term outlook for those companies with strong balance sheets, international diversification and green growth plans. I’d concentrate on these businesses not just today but for the next decade and beyond.