UK Prime Minister Rishi Sunak announced on 31 July 2023 his government’s commitment to award hundreds of new North Sea petroleum licences in the face of opposition from environmental groups and political opponents. Critics of the policy claim its incompatibility with the UK’s pathway to NetZero enshrined in UK law under the Climate Change Act. However, the UK’s independent Climate Change Committee predicts that hydrocarbons will continue to supply 25 percent of the UK’s energy by the time NetZero is achieved in 2050. Production from the UKCS has declined far faster than UK hydrocarbon consumption, increasing reliance on imports. The supply shock caused by Russia’s invasion of Ukraine has exposed vulnerabilities in the energy security of the UK and other major European economies which could be mitigated through North Sea production. Investors cite a track record of fiscal instability, as well as an uncertain political and regulatory outlook, as reasons to deploy capital elsewhere. What steps could the UK government take now to bridge these concerns and offer stability to investors?
Exploration for offshore hydrocarbon resources is a capital-intensive and inherently risky activity owing to the twin challenges of hostile operating conditions and the difficulty of locating economically viable reservoirs thousands of meters below the seabed. The infrastructure required to produce and transport those resources to market requires even greater capital deployment. Expenditures must be planned many years in advance, with significant lags between capital commitment and returns on investment, with production profiles from fields often measured in decades. To sanction investment, oil and gas companies, therefore, require some certainty as to the future fiscal and regulatory conditions under which their projects will be operated.
Questions about the role of hydrocarbons in the energy transition and declining investor sentiment have created a challenging global environment for investment in oil and gas exploration. The UK North Sea is further challenged by declining economically recoverable reserves and a comparatively high-cost base. The 2011 surprise increase in the supplementary tax charge on ring fence oil and gas profits, and the windfall tax introduced by the Energy Profits Levy in 2022, have damaged the North Sea’s reputation for fiscal stability with investors. And the opposition Labour Party recently announced its policy commitment to ban new oil and gas developments if elected in the general election in 2024. Onshore, the experience of the unconventional oil and gas industry, whose projects have been mired in legal challenges and effectively curtailed by a moratorium on drilling activity, serves as a further warning to investors of projects being overtaken by political concerns.
Investors may question whether there is sufficient certainty in the future UKCS fiscal and regulatory environment to sanction investment today in new petroleum licences and other upstream development. The UK government appears to, at least partially, recognize the problem and has opened a consultation seeking views on the long-term oil and gas fiscal regime that will run until 11 September 2023.
Two potential solutions present themselves:
- Fiscal stability: in many petroleum jurisdictions, host governments offer investors contractual “Economic Stabilization” rights, preserving the net effect of the fiscal terms applying to petroleum investments over the lifetime of projects, with recourse to international arbitration (often accompanied by protection under bilateral investment treaties), to give investors comfort that future profits from oil and gas field development will be realized under equivalent fiscal terms to those envisaged at the time of investment. In the UK there is precedent for using a contractual mechanism to preserve fiscal terms in the form of Decommissioning Relief Deeds, contracts entered into by the UK government and oil and gas companies, which provide certainty to oil and gas companies of the level of tax relief they will receive when decommissioning UKCS assets in the future. A similar arrangement could be offered to guarantee the application of current fiscal terms to all investment and profits realized from activities under future UKCS petroleum licences over the lifetime of the licences, effectively insuring investors against the risk of future tax hikes.
- Regulatory stability: it is a fundamental principle of the UK’s constitution that Parliament cannot bind itself by legislating today to limit its ability to pass laws in the future. Therefore the current UK government cannot prevent future governments from banning oil and gas development. Nevertheless, it is reasonable for investors to require some certainty that future projects will not be banned (and their exploration expenditure wasted) if they are to commit to exploration investment in the near term. To provide sufficient comfort to enable investment, the UK government could offer a guarantee to compensate licensees for their qualifying exploration expenditure (plus an appropriate financing fee) if a future government legislates to ban oil and gas development or refuses to approve development projects for fields discovered by their exploration activities. Such an arrangement could be structured as a liquidated damages provision within an economic side agreement to a licence. In addition to offering licensees the comfort that their exploration investments will be protected, such arrangements may also disincentivize future governments from prohibiting new field developments, if in consequence, they were to become liable for licensees’ wasted exploration costs.
These proposals may well be politically unpalatable. But they are likely to be the kind of solutions that current and potential investors in the UKCS will be looking for to facilitate their future investment in upstream oil and gas in the UK as part of the energy transition.
We look forward with interest to the contributions to the UK government’s consultation on the upstream fiscal regime and the government’s response to the consultation.