The cost of a windfall

Martin O'Neill explores the case for an energy windfall tax - and finds the potential impact on both

Energy companies have made excess profits during the recent spike in oil prices. Levying a windfall tax to recoup some of that profit for the public purse looks like a fine idea; but the truth might be more complex than appearances suggest. Windfall taxes are troublesome, and potentially counterproductive, mechanisms for promoting social justice.

Gas prices have risen by 100% since 2000, with electricity prices rising by 61% over the same period. Average annual spend on domestic energy now stands at a staggering £1200 per household; consequently, more and more people are falling into fuel poverty, unable to afford to heat their homes properly.

As the price ordinary citizens pay to put petrol in their cars and heat their homes has risen, so have the gigantic profits of energy companies. As the campaigning group Compass points out, the main UK energy providers have seen profits rise from £557 million in 2003 to over £3 billion today.

But even these gargantuan figures are dwarfed by the supernormal profits being made by the oil companies. BP has seen its profits rise 23%, with the company positing profits of £6.7 billion for the first half of 2008. Exxon’s most recent quarterly profit, for the period April-June 2008 is a record $11.68 billion, the largest quarterly profit every posted by a US company.

It certainly looks as if big business has used the recent spike in energy prices to engage in a shameless bout of rampant profiteering. Moreover, it has done so at enormous cost to ordinary consumers, and especially the poorest, who are now spending an ever greater proportion of their already stretched incomes on their basic energy needs.

The situation is a troubling one, and effective remedies are hard to come by. The solution proposed by the think tank Compass, and endorsed by a group of 50 Labour MPs, including former paymaster general and Brown ally Geoffrey Robinson, is for a one-off windfall tax to be levied against the energy companies. This tax would work on a similar model to the £4.5 billion windfall tax imposed by Brown on the privatized utilities in 1997, or the 1981 windfall tax that the Conservatives imposed on the main clearing banks.

Revenue raised by a windfall tax could be used, as in Compass’s proposal, both for immediate assistance to those in fuel poverty, and also for longer-term measures to reduce Britain’s demand for, and dependence upon, fossil fuels. This could potentially be achieved both through a massive programme of increasing domestic energy efficiency (through better insulation and other fuel efficiency measures), and also by bringing significant new investment to the development of renewable energy sources.

On the face of it, this seems to be an excellent proposal. It would achieve direct redistribution from big business back to the pockets of ordinary people. Moreover, it would do so whilst also pursuing green objectives, and reducing the country’s overall energy consumption.

There are, however, problems, both in terms of principle and in terms of their effectiveness and broader consequences, with the use of windfall taxes of this kind. The main objection of principle is that imposing a windfall tax amounts to changing the rules of the game while the game is in play.

A stable tax regime sets up “legitimate expectations” (to use John Rawls’s term) among property-owners, including the shareholders in energy companies, and the violation of those expectations can seem to be an instance of unfairness. This is not to say that the state is not entitled to impose heavy taxes on profiteering companies, but it is to say that such taxes should, insofar as possible, be imposed in a predictable, stable and uniform manner. One-off taxation can, by comparison, simply seem too arbitrary to be fully justifiable.

This worry may only go so far, though. For perhaps it should be part of the “legitimate expectations” of energy companies and their shareholders that stable tax arrangements can be supplemented with additional windfall taxes whenever there is a case of price-gouging or excessive profiteering.

This worry about expectations, though, connects with some of the practical difficulties of a windfall tax. One thing that will be likely to make companies wary of engaging in sufficient future investment is if they see themselves facing a volatile or unpredictable tax regime. A windfall tax might thereby scare away future investment from the energy companies in Britain’s energy infrastructure, but without securing an ongoing revenue stream for the Exchequer.

In this way, therefore, ‘one-off’ taxes can be the worst of both worlds, as stable taxation (even if it is at quite a high level) can be more advantageous for both governments and companies than volatile or unpredictable forms of taxation. Economists have a saying that “a good tax is an old tax” – i.e. a tax the effects of which have been taken into account by all relevant economic actors. One-off taxes, by definition, can never become “old taxes” in this way.

If we want to raise more revenue from the energy companies, there may well be a case for looking at the long-term reform of the way in which they are taxed, rather than hoping for one-shot solutions. This alternative approach has even more to recommend it if we consider the possibility that, far from being a temporary ‘spike’, high energy prices may instead be the shape of things to come.

Perhaps the largest problem with a windfall tax on the energy companies is the question of who would actually bear the burden of that tax. This burden is very likely to be passed on to consumers.

By the very fact of their supernormal profits, energy companies have demonstrated (a) that they have enormous market power, and (b) do not exist in a truly competitive market. If the energy market was truly competitive, we would have expected to see falls in consumer prices, as energy companies competed for market share. And of course one need only contemplate for a moment the massive costs for new entrants into the energy market to be unsurprised by the uncompetitive nature of the energy market.

Given that energy companies are so powerful, and that the energy market is an oligopoly of this kind, it is very unlikely that anything like the full costs of a windfall tax would be borne by the companies themselves. Instead, they would simply raise prices to consumers in order to make good their shortfall. In short, the very market situation that seems to make a windfall tax attractive may also ensure that it would not be particularly effective at achieving its goals.

The aims supported by Compass, and by other proponents of the windfall tax, are surely the right ones. We need to help those in fuel poverty, dilute the power of the energy companies, improve energy efficiency and explore greener energy alternatives. But the mechanisms for achieving these aims would still seem to require a degree of rethinking, or at least fine-tuning.