What you need to know about the energy windfall tax

The cat is finally out of the bag and Rishi Sunak has announced his plans for a windfall tax on energy companies. Here are the details and what it means for investors.

Energy companies will need to pay an extra 25% tax on their profits for one year in a move that’s predicted to raise around £5 billion for the Treasury. The funds will be used to help struggling families with their finances and energy bills. Government plans include a one-off £400 energy bill reduction for all families and a further £650 payment for the poorest households.

The oil and gas sector has had a stellar year. BP (LSE:BP.)’s first-quarter profits were the highest in 10 years, while Shell (LSE:SHEL) made a record £7 billion.

Those bumper profits are a stark contrast to UK household budgets. Many families are looking down the barrel of at least 50% increases in energy costs and facing rampant price increases for their other essentials. Average wages have risen a little, but nowhere near enough to keep up with inflation.

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Energy prices are through the roof and inflation stands at 9% so far this year. The energy price cap is expected to climb further to £2,800 in October, heaping even more pressure on families’ finances.

But what is a windfall tax? How does will it work? And will it affect your pension?

What is a windfall tax?

A windfall tax is an extra, one-off tax for companies that have made unexpected profits. It is charged on top of existing taxes: corporation tax and the supplementary charge for oil and gas companies.

Windfall taxes are unusual as the government prefers to raise tax regularly through corporation tax on company profits. Oil and gas companies currently pay corporation tax of 30% (higher than the standard 19%) and a supplementary charge of 10%, so 40% tax in total on their profits.

Why have energy companies made so much money?

In past 12 months, wholesale gas prices have tripled, and oil prices are up 67% from May 2021.

Oil and gas prices are set on the global energy market and vary, depending on worldwide demand and supply. If prices go up, oil and gas companies can make huge profits with no extra effort.

Increases in oil and gas prices are partly due to the Russian invasion of Ukraine. Russia is the second-biggest producer of both oil and gas in the world, pumping out 10.5 million barrels of crude oil per day and 638.5 billion cubic metres of gas per year during 2021.

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But even before the Ukraine conflict, oil and gas prices were climbing. A cold winter in Europe during 2020-21 depleted existing gas stores and increasing demand for oil and gas in Asia further stoked prices.

Shell, the biggest company in the FTSE 100, reported an eye watering $9.1 billion profit for the first quarter of 2022, compared with $3.2 billion during the same period in 2021 and $6.4 billion in the fourth quarter of 2021.

Likewise, BP had a record-breaking start to the year, reporting a surging profit of $6.2 billion compared to $2.6 billion during the same period last year.

How will the windfall tax work?

The windfall tax on energy companies is expected to raise around £5 billion over the next year.

Energy firms will pay a one-off extra levy of 25% of their profits on top of existing taxes. Rishi Sunak has confirmed that the levy won’t apply to electricity generation companies, so wind farms and other sustainable energy companies won’t be affected.

Energy companies will also be entitled to a new investment allowance if they invest in oil and gas extraction in the UK. The allowance will give firms 91p for every £1 they invest, meaning the more a company invests, the less tax they will pay.

Have windfall taxes been used before?

It’s not the first time the government has used windfall taxes to target successful companies.

Remember these?

• In 1981, Margaret Thatcher’s government introduced a windfall tax of an extra 2.5% on banks that had made massive profits off the back of sky-high interest rates of 17%.
• In 1997, Tony Blair’s Labour government raised £5.2 billion from previously privatised companies to help fund a welfare-to-work scheme.
• In 2011, George Osborne introduced an extra tax for North Sea oil and gas producers. He commented that “when oil prices are high...it is fair that companies should contribute more.”

Can energy companies afford it?

The simple answer is yes, energy companies probably can afford to pay a one-off levy.

They are likely to post bumper profits this year. The energy crisis shows no signs of letting up, meaning that they could be earning record profits for the foreseeable future.

A one-off 25% tax might slightly reduce investment in new technology next year but it’s unlikely to have much long-term impact.

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What do energy companies think?

Not surprisingly, some energy companies aren’t keen on the prospect of an increased levy.

In February, BP issued a public statement arguing that a windfall tax would discourage UK investment and would set back their transition towards sustainable energy.

However, sustainable energy companies will welcome the news that electricity generation companies will be excluded from the new levy. Critics had previously argued that taxing sustainable energy companies would be counter-productive and put back the UK’s transition to renewable energy.

How will a windfall tax be spent?

Rishi Sunak has announced a range of measures to help households with their energy bills, including the following one-off measures:

• £400 discount on energy bills for all families, due in October. The previously announced requirement to repay this amount has been scrapped.
• £650 cost of living payment for the poorest families.
• £300 payment to pensioners.
• £150 payment to people on disability benefits.

The measures come in addition to the £150 rebate on council tax, already given to households paying bands A to D council tax.

What are other countries doing?

Several other companies in Europe have already introduced a windfall tax.

In January, the Italian government raised the levy on energy companies from 10% to 25%. In early May the Italian prime minister, Mario Draghi, also introduced a €14 billion support package including a €200 cash payment for those on low incomes.

As early as last September, Spain scrapped all taxes on home energy bills, the tax shortfall paid instead by energy companies through a windfall tax.

Likewise, the French government has announced a €25 billion support package to support hard hit families. It’s also forced government-backed electricity supplier EDF Energy to lower the energy cap for customers.

In the Netherlands, the Dutch government has offered low-income families a one-off allowance of €600 to €800 and reduced VAT on energy from 21% to 9% until the end of the year.

What effect has the announcement had on share prices?

Share prices often move up or down based on anticipated news. This means that government announcements are often baked into prices before they’re made.

In this case, shares in the biggest electricity generators slumped on Tuesday. Drax (LSE:DRX), which owns a large power station in North Yorkshire, and British Gas owner Centrica (LSE:CNA), both fell on the news, but quickly recovered.

BP and Shell shares, more significant for most people’s pensions, have been unaffected by the announcement.

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Will energy stocks suffer in the long term?

The energy crisis shows no sign of easing and energy companies are unlikely to suffer from a windfall tax in the long run.

Several underlying factors suggest demand will continue to increase in the medium term. China’s oil and gas consumption will likely keep growing for the next five to 10 years, putting increasing pressure on global supplies. Germany’s decision to abandon nuclear power is also stoking increased demand.

Alongside these demand-pressures, long-term global under-investment in energy infrastructure, plus war in Ukraine have both contributed to supply problems. The relationship breakdown between Russia and Europe won’t be mended any time soon and supply shortages are likely to continue.

What does it mean for your pension?

If you’re an investor, then a one-off 25% levy on the profits of energy companies is unlikely to make a significant dent in your pension pot.

Many pension funds are well diversified and only invest a relatively small amount in the UK energy sector.

The Vanguard LifeStrategy 100% Equity Fund is only invested 5.6% in the energy sector and much of that investment is not UK-based.

If you do invest in a UK-only specialised energy fund or own shares in individual energy companies, then you’re more likely to feel the impact of the windfall tax.

Watch out if you own a commodities fund. Some funds are invested in mining and energy companies, rather than commodities themselves. This means that they may overlap with other funds in your portfolio. You may own shares in the same energy company through different funds, and you may not be as diversified as you think.