oil and gas subsidies

Natural gas fracking well in Louisiana

For years, the International Energy Agency has been measuring subsidies to consumers by looking at the gap between world reference prices for a particular form of energy and what that energy sells for in a country's domestic market.  The lower the cost to consumers relative to its world value, the higher the subsidy.   Russia has always been among the top of this list: in the IEA's 2010 update, Russia came in third with just under $40 billion in consumer subsidies.

Calculating consumer subsidies is not an easy task -- but it is downright simple compared to trying to figure out the many ways that a country lacking transparent fiscal systems subsidizes producers.  There are assorted tax breaks, but also production-sharing agreements, tremendous government ownership of energy-related assets and infrastructure, and complicated financing schemes by which credit is channeled to those and other projects.  Like China, the energy sector in Russia is very much a strategic asset of the government, and an extremely important one at that.  It is quite difficult to figure out precisely how this relationship plays out in terms of altering market relationships and prices. 

Dr. Ivetta Gerasimchuk, working with WWF-Russia and IISD's Global Subsidies Initiative, has done an admirable and detailed review of this arena in her recent study Fossil Fuels – At What Cost? Government support for upstream oil and
gas activities in Russia
.  The analysis touches on a number of critical themes:

  • Increasingly large subsidies to Arctic oil and gas production.  She notes that all parties recognize this production would not occur without subsidies.  Given the extremely fragile ecosystems in this part of the world, and the difficulty recovering from spills, subsidizing extraction there seem particularly foolish.  There is, however, lots of money at stake, and it is not just Russia that is rushing in to get in to stake their claims on Arctic resources.
  • Sovereign credit, sovereign control.  Federal credit support for a variety of energy projects is quite common, often at very high levels ($3-8 billion per project -- see p. 74).  Sovereign credit is even more common in the thermal power sector than oil and gas due to reduced access to capital markets.  The study notes that there is insufficient data on lending rates and risks to assess the subsidy value of this support.  Since oil and gas firms can borrow on global capital markets, the author believes that a core purpose of subsidized sovereign credits in that sector is to reduce the risk of a foreign takeover of the firms should they hit a period of financial distress.  Working through the role of federal credit on this infrastructure in more detail would be a very useful piece of follow-on research.
  • Lax enforcement of environmental regulations.  Even when there are statutes in place, they are rarely enforced.  Russia is not alone in this regard; however, it is nice to see the issue picked up explicitly in a subsidy review.  Unlike tracking environmental externalities, these are situations where existing law already assigns responsibility to the producing or transporting firm.  Lax enforcement means that the cost of paying for damages ends borne by taxpayers or the parties affected by the pollution, rather than in the delivered price of the fossil fuel.
  • Property tax exemptions and below-market tariffs for pipelines.  With a capital cost in the billions, it is hard to argue that pipelines are not valuable property.  Clearly they should pay property taxes where such charges are levied on other industries.  Exemptions in Russia are widespread at both the federal and municipal levels, according to Gerasimchuk's review, with a subsidy value of about $2 billion per year.  This is more evidence that the subsidies particular industries get are fairly consistent across the world.  The controversial Keystone XL pipeline in the US, slated to move tar sands from Canada to Texas, is also receiving significant property tax abatements from the states it crosses.  Another interesting element of Russian policy is the decision to subsidize oil exports to China by instituting artificially low tariffs on shipments through the East Siberia - Pacific Ocean pipeline (p. 103).  The subsidy was worth an estimated $1.1 billion in 2010.
  • Tax evasion through the use of transfer pricing.  Multinational firms can buy and sell goods and services to particular divisions at prices set to transfer the accounting profits to low-tax regions or to eliminate taxable income entirely.  Past efforts to curb the practice through legislation were of limited success.  An additional tightening of regulations is set to occur in 2012, but its success is also not yet proven.  The subsidies to the oil and gas sector in Russia are estimated in the billions of dollars per year.  My expectation is that better data would find tax avoidance significantly higher than people had expected.
  • Special terms in production sharing agreements and widespread municipal tax breaks for, and ownership of, energy-related enterprises.  These two important areas are discussed as well, with estimates where possible.  Additional research to quantify what are likely widespread subsidies at the municipal levels would be extremely useful.

The chart below links many of the core subsidies identified to stated objectives of the policies, and compares support for extending production from mature fields versus subsidizing new ones.  The objectives (shown in blue in the center) should be taken as directional rather than definitive.  Politics and money are both at play as well, and often tip policies towards those with power rather than towards those most likely to achieve stated social policy goals.

Russia ff subsidy graphic

Fossil Fuels – At What Cost? Government support for upstream oil and gas activities in Russia

The value of the Russian government’s support to the upstream oil and gas activities is very significant. The subsidies to oil and gas producers in Russia that have been identified and quantified in this report amounted to 4.2 per cent and 6.0 per cent of the total value of oil and gas production in Russia in 2009 and 2010 respectively. These subsidies also amounted to 8.6 per cent and 14.4 per cent of the industry’s total tax and other payments to the federal government in 2009 and 2010 respectively.

Natural gas fracking well in Louisiana

The Tax Foundation has penned a number of posts on the Section 199 Domestic Manufacturing Tax Deduction and the oil and gas industry.  This subsidy allows companies to deduct up to 9 percent of their net income from domestic manufacturing activities, in the process bringing down their overall corporate tax rate.

The Tax Foundation agrees that the provision is a subsidy in general, and that more industry-neutral methods to bring down general corporate tax rates would be less distortionary.  Their critique of removing the tax break independently for the oil and gas sectors is twofold:  that eliminating the subsidy to oil and gas would be ineffective in meeting environmental objectives, since market prices won't change; and that singling out this industry alone amongst all manufacturers is arbitrary and unfair.

Impact of subsidy reform on energy markets.  The question of how eliminating a particular subsidy provision will alter market prices is always a tough one.  Oil is widely traded, and the US is not a low-cost producer.  Thus, any cost increases from subsidy removal on the domestic market risk being competed away through increased imports, resulting in no change in price signals to consumers.  There are a handful of relevant responses here: 

First, natural gas is not so widely traded, and therefore domestic price increases from subsidy removal are more likely to flow through to domestic pricing and demand patterns. This is particularly true with gas moving to a marginal supplier position in power markets following fracking-related reductions in natural gas prices.

Second, focusing on the short-term impact of removing any single subsidy will inherently understate the benefits of broadscale subsidy reform.  Even if domestic equilbrium prices don't change immediately, subsidy removal often affects the structure of supply -- and sometimes in quite beneficial ways.  Removal of coal subsidies in the UK led to a significant increase in the share of cleaner natural gas in the power sector, for example.  Similarly, if countries stop subsidizing higher-cost sources of extraction, such as through royalty relief or special tax breaks for remote or less lucrative formations, alternative ways to provide energy services have a much better chance of gaining a market foothold. 

Third, the removal of groups of subsidies rather than a single one (basically what the Obama administration is trying to do in support of its G20 fossil fuel subsidy phase-out pledge) makes impacts on pricing and demand patterns much more likely.  It is important to remember that the US also subsidizes foreign oil production through the tax code, provision of subsidized credit, and oil security services.  Cutting all of the subsidies to both domestic and foreign production at once would be much more likely to affect domestic prices and inter-fuel substitution than limiting reform to the domestic industry only.  A related issue involves subsidies to oil and gas that arise through insufficient user fees.  The Strategic Petroleum Reserve, the inland waterway system (used heavily to move bulk coal and oil), and the highway system all have either no user fees at all or fees too low to allow the services to break-even (even on a non-profit, no return-on-investment basis).  Because these fees hit a large portion of domestic oil consumption, they are harder to bypass by switching suppliers.  Cost recovery for SPR, for example, could simply be added to the federal motor fuels excise tax.  The harder the fees to bypass, the more likely we'll see appropriate price signals to the end-user.

Is targeting oil and gas for section 199 exclusion arbitrary?  The second main line of criticism put forth by the Tax Foundation is that removing the section 199 credit only for oil and gas is arbitrary and unfair.  They point out that many other industries continue to get it, and that some of those industries (e.g., asphalt layers) also contribute to the fossil fuel reliance that the Administration is targeting through excluding the oil and gas sector.

The examples of related industries that get to keep the breaks miss what I think is a key problem with the tax credit:  what constitutes "manufacturing"?  If you invest in drilling rigs, oil refineries, and pipelines, that is as much manufacturing as making the asphalt for the roads or the vehicles that drive on them.

But the uranium ore, oil, gas or coal that is pulled from the ground has not been "manufactured."  Rather, it is part of a natural resource endowment that our country and its citizens are fortunate to have, and and that we have a responsibility to manage wisely.  So too with the water used in the extraction process or to irrigate the crops, and that is often degraded and polluted in the process.  Is pulling water from acquifers "manufacturing"?  The pipes and pumps may be, but the water itself is not. 

Yet in these, and likely many other cases, the endowment value of the resource itself is being counted as part of the domestic production gross receipts that are used to calculate the value of the tax subsidy.  Here is the specific Section 199 language of concern (emphasis added), courtesy of the Cornell Law Library:

4) Domestic production gross receipts

(A) In general
The term “domestic production gross receipts” means the gross receipts of the taxpayer which are derived from—
(i) any lease, rental, license, sale, exchange, or other disposition of—
(I) qualifying production property which was manufactured, produced, grown, or extracted by the taxpayer in whole or in significant part within the United States,
(II) any qualified film produced by the taxpayer, or
(III) electricity, natural gas, or potable water produced by the taxpayer in the United States...

While it may well make sense to kill the entire section 199 subsidy, making the endowment value of extracted natural resources ineligable would be a good start.

Tax and royalty-related subsidies to oil extraction from high cost fields: A study of Brazil, Canada, Mexico, United Kingdom and the United States

Discussion of fiscal regimes for oil extraction have traditionally focused on the total charges of all sorts levied on a project (the "total government take"), and whether their level and structure optimised oil production and public revenues.  Yet national, or global, policies to meet energy and environmental goals need to maximize benefits across complex energy and economic systems, not just specific projects.  This study argues that there is a need to reframe the debate on how fiscal regimes - notably tax and royalties - to fossil-fuel extraction are evaluated.  It further argues that su

Natural gas fracking well in Louisiana

Taxpayers for Common Sense (TCS), a Washington, DC-based organization focused on improved transparency in government budgeting and spending, has just completed a nice summary of the state-of-play in federal oil and gas royalty subsidies

Royalties are the payments that private firms make to the government to compensate the states owning the resources for natural resource wealth the firms have extracted from public lands.  They are normally a percentage of the market value of the resources extracted, so inherently adjust to changing market conditions.

While many countries have far worse transparency than the US in terms of who gets access to resources and what they pay, the US system continues to have its fair share of problems. These have spanned decades, and include problems with calculating the proper amounts, auditing the payment systems, and even some basic soap opera sleeping around messing with royalty collections.

Poor wording (assumedly unintentional, though at one point there was talk of a criminal inquiry though I'm not sure where it ended up) in lease agreements for production in the Gulf of Mexico has led to royalty-free extraction of billions of dollars of oil and gas even in periods of very high energy prices.  A lower court ruling in favor of oil companies was let stand by the US Supreme Court in October, and will result in an estimated $53 billion in lost royalties over the next 25 years.

Basic rules of risk sharing are routinely ignored in these contracts, with absolute royalty reductions granted rather than contingent reductions available only in adverse market conditions.  Won't happen again?  The Gulf incident was not the first time the feds have been tripped up on proper risk sharing for complex contracts.  The core issue is that legislators focused on changing rules for current market conditions have a hard time viewing technologies and markets as dynamic, or trying to plan for the wide array of potential outcomes as basic facts and conditions change. 

Foolishly worded contract agreements to provide a federally-run, break-even, repository for civilian nuclear wastes with little risk sharing by the private firms is another example of this generic problem.  As with the royalty scandal in the Gulf of Mexico, poor risk sharing on the nuclear waste repository is already starting to cost taxpayers dearly.

These two examples should be cautionary tales of how expensive simple mistakes in statutory wording can be.  Energy legislation running thousands of pages is becoming ever more frequent while the language and concepts contained in these bills are growing increasingly complex.  It should be expected that gaffes or intentional loopholes such as the Gulf royalty-free zone and the lack of risk sharing on nuclear waste contracts will sneak into the murky depths of this new legislation as well.  Yet, even as the public financial commitments keep growing, few people have read and understood the details of what is being proposed.

At least in the area of royalty relief, fixes seem straightforward.  New types of fuels in harder to reach locations are regularly trotted out as deserving of royalty relief.  Yet every industry has emerging technologies and applications with higher costs than existing products.  It is not surprising that the oil and gas sector, too, has a rising cost supply curve where some types of deposits are not economic with existing technologies or at current market conditions.  This is not a defect; it is a routine part of market functioning.  Oil and gas producers should be treated more like a routine industry, forced to innovate on their own dime towards making these emerging resources competitive, rather than continually seeking subsidy.  It hardly makes sense spending large amounts of public money to clamp down on carbon emissions on the one hand while subsidizing carbon extraction with the other.

Fueling Global Warming: Federal Subsidies to Oil in the United States

Extremely detailed, widely peer-reviewed, examination of subsidies to oil in the United States throughout every stage of the fuel cycle. Includes plain-language explanations of how different types of subsidy programs operate and why the are valuable to the recipient industries. This is useful background for subsidy policies even outside of the energy arena. The report includes evaluations of tax policies, direct government programs, loan subsidies, leasing arrangements, and post-closure and accident liabilities.