Bumper North Sea oil profits pose taxing questions for the Chancellor

Government threatens to penalise petrol companies if cuts in duty are not passed to motorists

The Government sent shockwaves through the United Kingdom oil industry yesterday by warning that it was considering a "windfall tax" to defray any excess profits being made on petrol forecourts.

The Government sent shockwaves through the United Kingdom oil industry yesterday by warning that it was considering a "windfall tax" to defray any excess profits being made on petrol forecourts.

This is not the first time such a tax has been proposed, and it comes in the wake of bumper profits posted by BP on Tuesday. But could such a tax work, and if so, how?

Windfall taxes are large one-off levies. The last was made in 1997 when the Government billed the privatised utilities some £5bn in the belief that it had sold them off to private investors too cheaply. If there is a justification for repeating the trick in the oil industry, it is that oil companies are benefiting unfairly from high oil prices.

However, the Government's use of the dreaded "w" word yesterday appeared to relate specifically to petrol retailing, the oil firms' "downstream" operations. Here, a windfall tax runs into difficulties. Prices may seem high to drivers, but that is because about 76p per pound spent on petrol goes to the Treasury. Indeed, BP and Shell, the UK's principal oil producers, complain that their domestic downstream businesses are loss-making.

So why do companies bother with petrol retailing at all? Could it be that it only appears loss-making, because the companies hide the profits in the "upstream" exploration production operations? In reality, modern accounting regulations make it hard to pull off any such stunt. It seems reasonable to accept the oil companies' explanation, that they are holding out in the hope that they can persuade drivers to make forecourts profitable again by purchasing more ready-meals, cuddly toys, CDs and the like.

But the Treasury is worried, fearing that cuts to duty announced in the November Budget after the fuel protests are not being passed on to drivers. "The Chancellor would hope that those duty cuts would be passed on to the consumer," a Treasury spokeswoman said. "Obviously if those cuts have not been passed onto the consumer and people complain ... the Treasury will consider action such as a windfall tax."

The companies reject any such allegations. But the argument does not end there.

There is mounting concern over what industry observers call the "supernormal" profits being made in the North Sea amid the continuing strength of the oil price. For oil explorers, the North Sea is among the world's most benign tax regimes, not least because the first Thatcher administration abolished special royalties and upped exploration allowances. The aim was to encourage companies to throw more investment into the fields to keep them flowing as they matured.

The biggest levy on North Sea oil production – the petroleum revenue tax – remained in full force until 1993, when it was abolished on new fields and slashed from 75 to 50 per cent on existing fields.

Academics say this has left the UK as an oddity among oil-producing nations. Ian Rutledge, an upstream oil expert at Sheffield University, says citizens are missing out on their fair share of profits from North Sea oil, which is the property of the state in the first place.

"The oil companies can't have it both ways and say they need support when the oil price is $13 [£9], but resist taxes when it is $28," he said. "Other companies pay for raw materials, or at least pay rent. Oil companies get them for free [in the UK]. They should pay for them as they do elsewhere in the world."

He rejects the idea of a windfall tax on bumper North Sea profits, preferring instead the reintroduction of royalties in the form of a supplementary corporation tax. "A windfall implies something one-off. But this is not about recouping money from privatised utilities. The only sense in which 'windfall' is appropriate is that the oil companies are benefiting from the strong oil price, which is not their own doing."

The oil firms say a stricter fiscal regime would force them to take their investment elsewhere, with catastrophic consequences for employment in Scotland. There is no shortage of glamorous locations in the world providing new drilling opportunities, whether they be offshore Vietnam, the deep waters around the Gulf of Mexico, or, politics permitting, Iran.

It is arguable that the benign regime in the North Sea is simply a product of market forces, and reflects the quality of the ore body there. Moreover, while the oil price appears stable following Opec's commitment to sustaining it between $22 and $28 a barrel, and there will always be the risk of a return to the $10 level of four years ago.

Yet it is debatable if the big oil firms would quit the North Sea. One City analyst said: "[The oil majors] threaten to take their investment elsewhere, but they're not doing much exploration. It can't be hard for someone to come up with a tax on supernormal profits when the price is high."

Mr Rutledge said: "If any company walked off in a huff, there would be plenty of others to take their place."

The question remains as to why the Government would risk upsetting the industry. The Treasury's coffers are amply stocked, and it would go against the environmental policy to pass on profits to drivers. Still, with March 2002 the earliest point at which Gordon Brown, the Chancellor, could introduce a windfall or supplementary corporation tax, there is plenty of time for him to find a use for the revenue it would raise.