Comment: How to make the most of Scots oil?

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WITH North Sea revenues set to decline, an independent Scotland faces difficult choices on taxes and levels of public spending, write Iain McLean, Jim Gallagher and Guy Lodge

But for North Sea oil, Scotland would probably not now be facing the choices it is. It fuelled the SNP in the 1970s with the slogan “It’s Scotland’s Oil”, and even the diminished oil revenues of today are at the heart of the Scottish Government’s fiscal arguments and its case that Scotland would be a richer country than the UK.

There are two questions about oil. Whose is it and what to do with it?

These days, there’s little argument that if Scotland were independent, it would have the benefit of oil – and be much better off than without it. There’s a purely statistical sense in which that makes Scotland richer: oil would then count as part of Scotland’s GDP, rather than as the offshore bit of the UK, and our per capita GDP would go up. But no-one would be a penny better off, so that is a red herring.

The interesting question is what to do with oil revenues. When they formed a significant proportion of the UK’s tax take, they were simply used to support current spending. The alternative is to create a sovereign wealth fund – a state-owned fund that (in countries such as Kuwait and Norway) invests the tax receipts from natural resource taxation.

Treating the oil taxes as a windfall to set against current expenditure was arguably a bad policy mistake. Oil and gas in the North Sea are part of the nation’s capital stock: which nation’s is disputed, but certainly some nation’s.

To tax this stock and spend the money on current expenditure is to deplete the stock. Rather, tax proceeds on capital receipts should be reserved in some form for capital expenditure or for creating a fund to permit future current expenditure once the stock of capital is depleted. Shetland did this to some degree, but the UK did not.

Of course, in the 1980s the UK was in a bad fiscal state, which would have been much worse if the windfall had not occurred. If an oil fund had been created then, either public expenditure would have had to be cut, other taxes increased, or government borrowing massively increased (or some mixture of all three, depending on the size of the fund).

The failure to set aside oil receipts in that period, of course, benefited Scotland as well as the rest of the UK in the short run, as more public services were delivered, more social security payments made and taxes were lower than would otherwise have been the case. As every household will know, borrowing to build up a savings fund makes little economic sense. The UK did not do it in the 1980s, and Scotland would face the same choice now.

There is a good deal of oil left out there, but future revenue is inevitably decreasing. Projections vary, but projected tax receipts fall off much faster than will projected production. Revenues will be significantly reduced by the oil companies’ right to offset their decommissioning costs against their tax liability.

The oil industry is under an obligation to reinstate the North Sea to its original condition once they have finished sucking the oil out. The estimated cost of doing this is uncertain, but big. A figure of £30 billion has been suggested. The industry has recently been negotiating with the UK government on how this large future cost will be offset against taxation. It has come to complex agreements to get some certainty that it will get tax relief on expenditure that will be incurred, quite probably, many years after the tax has been paid. Also, in many cases the big operators are selling on the wells to smaller companies.

Those smaller companies may be less financially secure, and less able to pick up the decommissioning costs, which may fall back on the bigger companies. So, the original big operators have an incentive to strike a deal with the UK government to give them some kind of legal protection for tax relief on any decommissioning expenditure they have to pick up in those circumstances as well. The effect of this is that HM Revenue and Customs included in its accounts a charge of £20bn for lost tax in future as a result of the relief on decommissioning. The effects of this on UK public finance projections were dramatically shown in the Office for Budget Responsibility’s drastic downward revision of revenue forecasts.

To what extent would this obligation to give relief be transferred to an independent Scotland? From the oil companies’ perspective, a deal struck with one government should be honoured by its successor, especially when it concerns long-term tax liabilities and claims; although promises about taxation might well be hard to enforce in any court, independence or not.

It’s pretty clear, however, that the post-independence Scottish government would argue that as it was the UK that had made these promises, and had the benefit of the tax revenue, it should be the UK that inherits the obligation to give the companies tax relief. But as this would be relief on tax they would no longer be liable to pay to the UK, it is not clear how that could happen. The result is that this is bound to be an issue in negotiations after a Yes vote.

How long will the oil last? Nobody knows. Exploration in the North Sea is still going on. But it is not just a matter of finding oil, it is also a matter of deciding whether or not it is worth bringing to the surface, transporting, and refining.

That depends on the future of oil prices, which nobody knows. It also depends on the future price of things that are sufficiently like oil to be substitutes for it. The most obvious of these is gas.

All other things being equal, the higher the oil price, the longer North Sea extraction is likely to continue, because the higher the oil price the more it is worth exploring for new reserves.

In a typical “high price” scenario, with oil at US $90 a barrel and gas at 60p a therm, production increases from 2012 levels to a plateau of about a third more than at present from 2018 to 2028, whereupon, as in the medium price scenario, it declines by 2042 to half the current level. Tax receipts will not follow the same path. At any given level of production, tax receipts in future years are likely to be lower than in past years.

These numbers are necessarily uncertain. But two things are certain: the amount that could now be put into any sovereign wealth fund is a fraction of 
what it might once have been; and it would be a foolish Scottish government that planned future public expenditure on the basis that tax receipts from North Sea oil and gas would continue indefinitely at present levels.

If it puts a substantial proportion of the tax receipts into a sovereign-wealth fund (as it certainly should), then it will face an unpalatable choice between increasing non-oil taxes and cutting current public expenditure. Or both.

• Scotland’s Choices: The Referendum And What Happens Afterwards, written by Iain McLean, Jim Gallagher and Guy Lodge is published on 18 April (Edinburgh University Press, price GBP12.99). Copies can be ordered direct by phoning 0131-650 4218.