## Introduction (insea2022002)

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---

### Overview and context
- Fossil fuel prices have surged during 2022, boosting profits for many energy companies while increasing pressure on households and businesses.
- The surge has prompted renewed policy interest in taxation of windfall profits in the energy sector; some countries have introduced exceptional tax measures in response.
- This note provides guidance for policymakers on options for taxing windfall profits and presents an overview of current practice for taxing windfall profits—or more generally, economic rents—originating from the extraction of fossil fuels.
- Figure timing notes:
  - Fossil fuel prices data are through the end of July 2022.
  - Electricity prices data are through the end of June 2022.

### Economic rents and windfall profits
- Economic rents:
  - Originate primarily at the upstream point of extraction rather than mid- or downstream segments.
  - Are defined as the return on an investment above the minimum threshold needed for the investment to be undertaken, with both location-specific and cyclical components.
- Windfall profits:
  - Intuitively arise from an unanticipated event unaffected by the investor’s actions (for example, a surge in commodity prices benefiting a project after an investment decision).
  - In practice, it is difficult to distinguish windfall profits from the cyclical component of economic rents; a tax designed to capture economic rents will effectively tax windfall profits as well.

### Recent price and profit developments
- Fossil fuel prices increased significantly since the Russian invasion of Ukraine, amplifying the post-COVID-19 recovery price rebound and coinciding with reduced fossil fuel investment stemming from anticipation of the energy transition and competitiveness of low-carbon alternatives.
- Natural gas prices have increased most sharply in Europe, driving up electricity prices.
- The increase in commodity prices is driving higher profits in fossil fuel-producing countries and extractive companies.

### Tax policy guidance: principles
- Tax policy design objectives: efficiency, ease of collection, equity, and revenue-raising ability.
- Taxes on economic rents are efficient because they do not reduce investment (they apply only to returns above required returns) and can raise substantial revenue where rents persist.
- Ordinary corporate income taxes and royalties:
  - Corporate income taxes apply to both rents and the normal return on investment and can reduce investment/supply.
  - Royalties do not consider firm costs and can reduce supply more than taxes on rents.
- Policy should be tailored by stage of the energy value chain because economic rents generally originate upstream, though temporary windfalls may occur mid- and downstream.

### Taxing windfall profits from upstream extraction — guidance
- Best practice: include a rent-targeting fiscal instrument in the upstream fiscal regime from the outset rather than introducing new taxes after investment decisions.
  - Advantages include better investor certainty ex ante and reduced political pressure to introduce ad hoc instruments if windfalls materialize.
  - Where countries rely more on rent-targeting instruments, fiscal revenue may be more volatile and require a macro-fiscal framework that saves a higher share of windfall revenue to promote intergenerational equity.
- Menu of rent-sharing fiscal instruments (listed in order of how well each targets rents):
  - Cumulative-rate-of-return-based cash flow tax:
    - Assessed on project cash flow and applies only after a minimum “normal” rate of return has been realized; taxes only excess return.
    - Neutrality achieved by uplifting negative cash flow by the threshold rate of return (or refunding tax value of losses, which increases government risk).
    - Ring-fenced at the project level; more challenging to administer and requires transition rules if introduced after project development.
  - Project-level tax with uplift on capital expenditure:
    - Simpler variant; applies a percentage uplift to qualifying capital expenditure over a specified period to ensure minimum return is not taxed.
  - R-factor–based progressive profit-oil sharing:
    - Common in production-sharing contracts; profit-oil sharing follows a progressive rate structure linked to the ratio between cumulative net revenue and investment (the R-factor).
    - The R-factor does not incorporate time value of money; setting the bottom R-factor threshold above one can approximate this.
  - Supplementary tax on corporate profits when a profitability threshold is met:
    - Relatively easy to apply, does not require ring-fencing at project level, but is less well targeted at rents.
    - Targeting can be refined by progressive rates linked to measures of profitability (for example, return on assets) or proxied by commodity prices.
  - Variable royalty rate linked to commodity prices:
    - Easy to apply but less well targeted at economic rents and can reduce supply since the tax increases variable production costs.
- Country-level choice should balance rent-targeting ability versus administrative complexity and consider:
  - Administrative capacity constraints and the need to prioritize capacity building for efficient regimes.
  - Ease of application to existing projects (some instruments require complex transitional rules or access to project-level historical data and may be constrained by fiscal stability clauses in contracts).
- General guidance on timing and permanence:
  - Introducing a temporary tax in response to a price surge can be distortionary and increase investor uncertainty—particularly if not well targeted at rents or poorly timed.
  - To counter increased uncertainty, temporary windfall taxes sometimes include generous investment allowances (example cited: UK energy profit levy with an 80 percent investment allowance), which can promote short-term investment in fossil fuels.
  - Where fiscal space allows, a permanent, well-designed rent-targeting mechanism is preferable to temporary measures; determination is country-specific and should account for overall upstream taxation levels and responsiveness to profitability changes.

### Administrative and design trade-offs (summary)
- Cumulative-rate-of-return-based cash flow tax:
  - Ability to target rents: High (taxes only rents if uplift rate is at or above investor’s required return).
  - Administrative complexity: Medium (requires oversight and auditing of project-level revenues and costs; uplift rate is contentious).
  - Scope: Project level; difficult to apply to existing projects.
- Project-level tax with uplift on capital expenditure:
  - Ability to target rents: Project level, more easily applied to existing projects.
  - Administrative complexity: Requires determination of qualifying capital cost categories.
- R-factor–based progressive profit oil sharing:
  - Ability to target rents: Medium (R-factor omits time value of money).
  - Administrative complexity: Project level; difficult to apply to existing projects.
- Supplementary tax on corporate profits:
  - Ability to target rents: Low to medium (loss-making and non-extraction activities remove portion of project-level rents).
  - Administrative complexity: Low (calculated and audited using existing corporate income tax return information).
  - Scope: Corporate level; applies to existing projects.
- Variable royalty rate linked to commodity prices:
  - Ability to target rents: Low (does not account for project cost structure; increases variable cost of production).
  - Administrative complexity: Low (calculated and audited using existing royalty information).
  - Scope: Project level; easy to apply to existing projects.

### Emissions and environmental considerations
- Fiscal regime design should prioritize reducing direct greenhouse gas emissions from fossil fuel production (Scope 1 emissions).
- A mixture of regulatory and price measures can be used to incentivize less-emitting production methods and reservoirs during the energy transition.
- Norway is cited as an example of integrating carbon and methane taxes into a petroleum fiscal regime while maintaining overall high progressivity without discouraging investment.

### Windfalls outside producer countries and mid-/downstream sectors
- Windfall profits are likely concentrated in specific fossil fuel-producing countries rather than importers; this can create political pressure in net-importing countries or countries where energy multinationals are headquartered to capture rents generated abroad.
- There are few tax policy options for taxing fossil fuel imports that do not further raise consumer prices.
- Mid- and downstream examples:
  - Refining: Constraints in refinery capacity (for example, in the United States) have led to surges in refiner profits (the “crack spread” between crude oil and wholesale fuel products, especially diesel).
  - Electricity producers: Fixed-cost electricity producers (renewable, nuclear, fossil-based with fixed fuel contracts) can receive windfalls as electricity prices rise (notably in Europe with higher natural gas prices).
- Policy cautions for electricity and refineries:
  - The case for rent-targeting taxes in the electricity sector is weak; taxing renewable energy producers sends mixed signals when priority is energy diversification away from fossil fuels.
  - Temporary windfall taxes reduce future investment as investors internalize the likelihood of such taxes; expedited political design of such taxes often leads to poor design and increased harm to investment.
  - Taxes on gross revenue are especially distortive and can exacerbate inflation if they increase marginal costs for many suppliers.

---

### Box 1 — Comparison of Increased Pre-tax Retail Prices and Crude Oil Prices

### Key findings on retail spreads
- Tax-free retail prices have increased by more than international oil prices in the United States and some European countries, indicating mid- and/or downstream companies are receiving a portion of windfalls from oil price increases.
- Spreads (difference between crude oil prices and gasoline/diesel retail prices, excluding taxes) have increased relatively more in the United States than in the average European country and more for diesel than for gasoline.
- The average increase in spreads:
  - Gasoline spreads are currently ~$0.15 per liter (~65 percent) higher in Europe and the United States than the 2019 average.
  - Diesel spreads are $0.15 per liter higher in Europe (56 percent) and $0.34 per liter higher in the United States (112 percent).
- There is significant variation across European countries: in some countries spreads decreased; in others the increase exceeded that in the United States.

### Evidence on refinery profits and industry profitability
- EIA analysis finds that refinery profits increased substantially across all regions within the United States in 2021 relative to 2020 and are above or near 10-year highs.
- EIA analysis shows that crack spreads were elevated in Europe and Singapore in recent months.
- Annex 2: Largest oil and gas companies experienced increased profitability in Q1 2022; return on equity and net income for Q1 2022 far exceeded the previous four years. Upstream/extraction activities drove profit increases into early 2022; in Q2 2022 refining and downstream sales contributed more but exploration and production still drove profit increases.

### Drivers of higher spreads
- Reduced refining utilization and petroleum product export quotas in China.
- Reduced supply of Russian petroleum products due to sanctions.
- Reduced US capacity due to some refineries shutting down.
- Inelastic refining supply since refineries are operating near capacity and it takes time to build new capacity.
- Increased demand for petroleum products from the COVID recovery.
- Conclusion: These factors allow operating refineries to increase prices, but markets should eventually rebalance and return to pre-COVID conditions.

### Policy options and design considerations for mid-/downstream firms
- If economic rents are consistently earned by electricity generators and oil refiners, policymakers should identify and remedy root causes; for electricity generation, windfall profits are at least partly a by-product of the tariff-setting mechanism design—strengthening the tariff-setting mechanism may be fruitful.
- An excess profits tax on such companies could provide a backstop against future windfall profits.
- Design requirements for a more permanent excess profits tax:
  - Apply to a clear, well-defined measure of excess profits (for example, the return on capital above a specified level).
  - Allow for carryforward of losses.
  - Avoid parameters that reference a particular time period or price level.
  - These design characteristics help avoid distorting investment decisions by taxing only profits above the cost of capital and avoid ad hoc adjustments as market conditions change.

### Country practices: fiscal instruments targeting economic rents or windfall profits
- Many countries with fossil fuel extraction already have upstream fiscal instruments targeting economic rents with flat or variable rate structures (examples cited in text: Norway special petroleum tax; progressive R-factor–based production sharing; rate-of-return-based instruments in Angola and Australia).
- Some countries vary income tax or royalty rates with commodity prices (examples cited: Canada, Nigeria, Trinidad and Tobago).
- Examples of additional taxes: supplementary charge and energy profits levy in the United Kingdom.
- The United States is noted as having a fiscal regime less responsive to surges in profits.
- Several European countries introduced or announced temporary taxes or fiscal mechanisms to capture windfall profits (mostly targeting electricity sector; one case fossil fuel extraction):
  - Greece: Imposed a 90 percent levy on windfall profits of domestic power producers for the period October 2021–March 2022.
  - Hungary: Announced a temporary windfall tax for 2022 and 2023 on “extra profits” from energy companies; in the energy sector the tax applies on revenue generated from the difference between world market oil prices and actual prices paid on imports of oil products from Russia with a 40% tax rate (the rate was 25% until the end of July 2022).
  - Italy: Introduced a one-time 25 percent tax on energy companies (producers and sellers of electricity, natural gas, and petroleum products). The tax applies to company profits that rose more than €5 million between October 2021 and April 2022 compared with the same period in the previous year.
  - Spain: Announced a temporary windfall profits tax for extraordinary profits earned in 2022 and 2023 by electricity utility companies.
  - Romania: Introduced an 80 percent windfall profits tax on additional revenue realized by electricity producers calculated on the monthly difference between the average selling price and 450 lei per megawatt hour; the tax was subsequently modified to apply to net revenue, taking account of costs. The government also adjusted the fiscal regime for natural gas, introducing a progressive tax of 15 percent to 70 percent on additional income on gas prices above 85 lei (about $18) per megawatt hour.
  - United Kingdom: The energy profits levy, introduced in July 2022 and set to expire by the end of 2025, is an additional 25 percent tax on oil and gas profits on top of existing taxes, taking the combined rate to 65 percent. Previous losses or decommissioning expenditure cannot be offset against profits subject to the levy. To encourage new investment, there is an additional 80 percent investment allowance. The levy does not apply to electricity generation.
- European Commission guidance on temporary windfall profits taxes for electricity generators requires that such taxes be temporary, preserve market signals (not increase marginal costs), discriminate based on generation technology, and use clear and verifiable criteria for determining “excessive” rents.

---

### Fiscal regime evaluation and annex summaries

### FARI framework and government take
- Analysis uses the Fiscal Analysis of Resource Industries (FARI) framework.
- Average effective tax rates (AETRs) for a selected group of large producers range from 35 to 90 percent.
- Jurisdictions with AETRs above 70 to 80 percent when prices are high (for example, Norway and Saudi Arabia) collect a large portion of project profits and have no basis for imposing new taxes in response to windfalls.
- Countries with AETRs (far) below 70 percent (for example, Mexico, United States, and United Kingdom before introduction of the energy profits levy) generally do not have robust rent-targeting mechanisms in their fiscal regime.
- Introduction of the temporary energy profits levy makes the United Kingdom petroleum fiscal regime less of an outlier.

### Progressivity, revenue responsiveness, and breakeven price
- Fiscal regimes relying on profit-based mechanisms have relatively stable AETRs across different profitability outcomes because the tax base (and sometimes the tax rate) grows as prices increase; regimes with higher royalties and no excess profit taxation have declining AETRs because pretax profit grows faster than the tax base.
- Fiscal regimes including a progressive instrument result in more stable outcomes as prices change and greater certainty for investors.
- Short-term response of government revenue to a price shock generally mimics progressivity: higher short-term response (higher elasticity) means the government takes on a larger portion of short-term commodity price risk.
  - Fiscal regimes with profit-based mechanisms tend to have larger immediate changes to revenue (examples: Algeria and Norway).
  - Royalties and indirect taxes are less responsive because the tax base change is less pronounced.
- Breakeven price insight:
  - Taxes independent of profit levels generally result in higher breakeven prices because they apply regardless of project profitability (examples: carbon taxes in Norway and Canada; royalties in most countries).
  - Taxes targeting economic rents are non-distortionary and should not prevent investment.
  - Example: Norway’s AETR is ~85 percent compared with ~40 percent for offshore US projects, yet the breakeven price is only $5 per barrel higher because Norway’s excess profits tax increases government take when prices are high but imposes only a small or no burden on less-profitable projects.
  - Note: investor minimum return is assumed to be 13 percent in real terms in the breakeven price analysis.

### Annex summaries and modeling notes
- Annex 1 (Methodology): Country-level impact of recent oil, gas, and coal price increases is estimated at an aggregate level for consumers and producers using 2019 production and consumption levels (with an adjustment for Russia). Producer price increases use the difference between the average price from March 2021 to July 2022 and the average price for 2019 for exported production; domestically consumed production is valued at the change in domestic retail prices. Government revenue increases are estimated using average effective tax rates from the FARI model (or world average if missing). Consumer impact uses observed consumer prices or estimates from historical relationships.
- Annex 1 (Windfalls by country): Combined gains for producers and governments of several large fossil fuel producers exceed 10 percent of GDP; gains are generally largest for natural gas producers, especially those selling into European markets. The gain to producers and government offsets the consumer loss in almost all cases (exception: India).
- Annex 2 (International Oil Company Profits): Largest oil and gas companies saw increases in profitability in Q1 2022; upstream segment drove profits through early 2022, with some shift toward refining and downstream contributions in Q2 2022 though exploration and production remained significant profit drivers.
- Annex Figure 2.1:
  - Return on equity (percent): charted for large oil and gas companies (no numerical series in text).
  - Net income, quarterly average (billions of US dollars): charted for large oil and gas companies; Saudi Aramco excluded from the net income chart due to very high income: "$10 to $39 billion quarterly average in each year."
  - PetroChina and Saudi Aramco had not reported their second quarter 2022 earnings at the time of the analysis.
- Annex 3: Fiscal regimes for comparator countries — key findings:
  - All modeled countries apply corporate income tax to the extractive sector.
  - Mixed use of royalties and rent-targeting taxes across modeled countries.
  - Seven countries have royalties, with rates ranging from five to 50 percent.
  - Three countries have royalty rates that vary with commodity prices (Canada, Mexico, Saudi Arabia).
  - Seven countries have rent-targeting taxes with varying designs:
    - Three allow for additional deductions to capital (Norway) or all expenses (Brazil and Kazakhstan).
    - Two are cash flow taxes with uplift on losses (Australia and Russia).
    - Algeria has a tax rate increasing with the R-factor.
    - The United Kingdom provides a surcharge on the corporate income tax base but without a deduction for interest.
  - Five countries have significant equity interests; all modeled equity interests are assumed to pay their share of exploration costs (conclusive information not available for Algeria and Kazakhstan).
  - Modeled regimes are intended to capture the design applicable to most existing projects; they may not reflect the most recent statutory structure.

*Source: insea2022002 - Introduction; Box 1; Annexes.*

### Introduction

### Introduction

### Overview and context
- Fossil fuel prices have surged during 2022, boosting profits for many energy companies while increasing pressure on households and businesses.
- The surge has prompted renewed policy interest in taxation of windfall profits in the energy sector; some countries have introduced exceptional tax measures in response.
- This note provides guidance for policymakers on options for taxing windfall profits and presents an overview of current practice for taxing windfall profits—or more generally, economic rents—originating from the extraction of fossil fuels.
- Figure timing notes:
  - Fossil fuel prices data are through the end of July 2022.
  - Electricity prices data are through the end of June 2022.

### Economic rents and windfall profits
- Economic rents:
  - Originate primarily at the upstream point of extraction rather than mid- or downstream segments.
  - Are defined as the return on an investment above the minimum threshold needed for the investment to be undertaken, with both location-specific and cyclical components.1,2
- Windfall profits:
  - Intuitively arise from an unanticipated event unaffected by the investor’s actions (for example, a surge in commodity prices benefiting a project after an investment decision).
  - In practice, it is difficult to distinguish windfall profits from the cyclical component of economic rents; a tax designed to capture economic rents will effectively tax windfall profits as well.3

### Recent price and profit developments
- Fossil fuel prices increased significantly since the Russian invasion of Ukraine, amplifying the post-COVID-19 recovery price rebound and coinciding with reduced fossil fuel investment stemming from anticipation of the energy transition and competitiveness of low-carbon alternatives.
- Natural gas prices have increased most sharply in Europe, driving up electricity prices.
- The increase in commodity prices is driving higher profits in fossil fuel-producing countries and extractive companies (see Annexes 1 and 2 for producer profit information).

### Tax policy guidance: principles
- Tax policy design objectives: efficiency, ease of collection, equity, and revenue-raising ability.
- Taxes on economic rents are efficient because they do not reduce investment (they apply only to returns above required returns) and can raise substantial revenue where rents persist.
- Ordinary corporate income taxes and royalties:
  - Corporate income taxes apply to both rents and the normal return on investment and can reduce investment/supply.
  - Royalties do not consider firm costs and can reduce supply more than taxes on rents.
- Policy should be tailored by stage of the energy value chain because economic rents generally originate upstream, though temporary windfalls may occur mid- and downstream.

### Taxing windfall profits from upstream extraction — guidance
- Best practice: include a rent-targeting fiscal instrument in the upstream fiscal regime from the outset rather than introducing new taxes after investment decisions.
  - Advantages include better investor certainty ex ante and reduced political pressure to introduce ad hoc instruments if windfalls materialize.
  - Where countries rely more on rent-targeting instruments, fiscal revenue may be more volatile and require a macro-fiscal framework that saves a higher share of windfall revenue to promote intergenerational equity.
- Menu of rent-sharing fiscal instruments (listed in order of how well each targets rents):
  - Cumulative-rate-of-return-based cash flow tax:
    - Assessed on project cash flow and applies only after a minimum “normal” rate of return has been realized; taxes only excess return.
    - Neutrality achieved by uplifting negative cash flow by the threshold rate of return (or refunding tax value of losses, which increases government risk).
    - Ring-fenced at the project level; more challenging to administer and requires transition rules if introduced after project development.
  - Project-level tax with uplift on capital expenditure:
    - Simpler variant; applies a percentage uplift to qualifying capital expenditure over a specified period to ensure minimum return is not taxed.
  - R-factor–based progressive profit-oil sharing:
    - Common in production-sharing contracts; profit-oil sharing follows a progressive rate structure linked to the ratio between cumulative net revenue and investment (the R-factor).
    - The R-factor does not incorporate time value of money; setting the bottom R-factor threshold above one can approximate this.
  - Supplementary tax on corporate profits when a profitability threshold is met:
    - Relatively easy to apply, does not require ring-fencing at project level, but is less well targeted at rents.
    - Targeting can be refined by progressive rates linked to measures of profitability (for example, return on assets) or proxied by commodity prices.
  - Variable royalty rate linked to commodity prices:
    - Easy to apply but less well targeted at economic rents and can reduce supply since the tax increases variable production costs.
- Country-level choice should balance rent-targeting ability versus administrative complexity and consider:
  - Administrative capacity constraints and the need to prioritize capacity building for efficient regimes.
  - Ease of application to existing projects (some instruments require complex transitional rules or access to project-level historical data and may be constrained by fiscal stability clauses in contracts).
- General guidance on timing and permanence:
  - Introducing a temporary tax in response to a price surge can be distortionary and increase investor uncertainty—particularly if not well targeted at rents or poorly timed.
  - To counter increased uncertainty, temporary windfall taxes sometimes include generous investment allowances (example cited: UK energy profit levy with an 80 percent investment allowance), which can promote short-term investment in fossil fuels.
  - Where fiscal space allows, a permanent, well-designed rent-targeting mechanism is preferable to temporary measures; determination is country-specific and should account for overall upstream taxation levels and responsiveness to profitability changes.

### Administrative and design trade-offs (summary of Table 1)
- Cumulative-rate-of-return-based cash flow tax:
  - Ability to target rents: High (taxes only rents if uplift rate is at or above investor’s required return).
  - Administrative complexity: Medium (requires oversight and auditing of project-level revenues and costs; uplift rate is contentious).
  - Scope: Project level; difficult to apply to existing projects.
- Project-level tax with uplift on capital expenditure:
  - Ability to target rents: Project level, more easily applied to existing projects.
  - Administrative complexity: Requires determination of qualifying capital cost categories.
- R-factor–based progressive profit oil sharing:
  - Ability to target rents: Medium (R-factor omits time value of money).
  - Administrative complexity: Project level; difficult to apply to existing projects.
- Supplementary tax on corporate profits:
  - Ability to target rents: Low to medium (loss-making and non-extraction activities remove portion of project-level rents).
  - Administrative complexity: Low (calculated and audited using existing corporate income tax return information).
  - Scope: Corporate level; applies to existing projects.
- Variable royalty rate linked to commodity prices:
  - Ability to target rents: Low (does not account for project cost structure; increases variable cost of production).
  - Administrative complexity: Low (calculated and audited using existing royalty information).
  - Scope: Project level; easy to apply to existing projects.

### Emissions and environmental considerations
- Fiscal regime design should prioritize reducing direct greenhouse gas emissions from fossil fuel production (Scope 1 emissions).
- A mixture of regulatory and price measures can be used to incentivize less-emitting production methods and reservoirs during the energy transition.
- Norway is cited as an example of integrating carbon and methane taxes into a petroleum fiscal regime while maintaining overall high progressivity without discouraging investment.

### Windfalls outside producer countries and mid-/downstream sectors
- Windfall profits are likely concentrated in specific fossil fuel-producing countries rather than importers; this can create political pressure in net-importing countries or countries where energy multinationals are headquartered to capture rents generated abroad.
- There are few tax policy options for taxing fossil fuel imports that do not further raise consumer prices.
- Mid- and downstream examples:
  - Refining: Constraints in refinery capacity (for example, in the United States) have led to surges in refiner profits (the “crack spread” between crude oil and wholesale fuel products, especially diesel).
  - Electricity producers: Fixed-cost electricity producers (renewable, nuclear, fossil-based with fixed fuel contracts) can receive windfalls as electricity prices rise (notably in Europe with higher natural gas prices).
- Policy cautions for electricity and refineries:
  - The case for rent-targeting taxes in the electricity sector is weak; taxing renewable energy producers sends mixed signals when priority is energy diversification away from fossil fuels.
  - Temporary windfall taxes reduce future investment as investors internalize the likelihood of such taxes; expedited political design of such taxes often leads to poor design and increased harm to investment.
  - Taxes on gross revenue are especially distortive and can exacerbate inflation if they increase marginal costs for many suppliers.

*Source: insea2022002 - Introduction (insea2022002 - Introduction).*

### Box 1. Comparison of Increased Pre-tax Retail Prices and Crude Oil Prices

### Box 1. Comparison of Increased Pre-tax Retail Prices and Crude Oil Prices

### Key findings
- Tax-free retail prices have increased by more than international oil prices in the United States and some European countries, indicating that mid- and/or downstream companies are receiving a portion of windfalls from oil price increases.
- Spreads (difference between crude oil prices and gasoline/diesel retail prices, excluding taxes) have increased relatively more in the United States than in the average European country and more for diesel than for gasoline.
- The average increase in spreads:
  - Gasoline spreads are currently ~$0.15 per liter (~65 percent) higher in Europe and the United States than the 2019 average.
  - Diesel spreads are $0.15 per liter higher in Europe (56 percent) and $0.34 per liter higher in the United States (112 percent).
- There is significant variation across European countries: in some countries spreads decreased; in others the increase exceeded that in the United States.

### Evidence on refinery profits and industry profitability
- US Energy Information Administration (EIA) analysis finds that refinery profits increased substantially across all regions within the United States in 2021 relative to 2020 and are above or near 10-year highs (EIA 2022a).
- EIA analysis shows that crack spreads were elevated in Europe and Singapore in recent months (EIA 2022b).
- Annex 2: Largest oil and gas companies experienced increased profitability in Q1 2022; return on equity and net income for Q1 2022 far exceeded the previous four years. Upstream/extraction activities drove profit increases into early 2022; in Q2 2022 refining and downstream sales contributed more but exploration and production still drove profit increases.

### Drivers of higher spreads (confluence of temporary events)
- Reduced refining utilization and petroleum product export quotas in China.
- Reduced supply of Russian petroleum products due to sanctions.
- Reduced US capacity due to some refineries shutting down.
- Inelastic refining supply since refineries are operating near capacity and it takes time to build new capacity.
- Increased demand for petroleum products from the COVID recovery (EIA 2022b).
- Conclusion: These factors allow operating refineries to increase prices, but markets should eventually rebalance and return to pre-COVID conditions.

### Policy options and design considerations
- If economic rents are consistently earned by electricity generators and oil refiners, policymakers should identify and remedy root causes; for electricity generation, windfall profits are at least partly a by-product of the tariff-setting mechanism design—strengthening the tariff-setting mechanism may be fruitful.
- An excess profits tax on such companies could provide a backstop against future windfall profits.
- A more permanent excess profits tax could be considered; design requirements:
  - Apply to a clear, well-defined measure of excess profits (for example, the return on capital above a specified level).
  - Allow for carryforward of losses.
  - Avoid parameters that reference a particular time period or price level.
  - These design characteristics help avoid distorting investment decisions by taxing only profits above the cost of capital and avoid ad hoc adjustments as market conditions change.

### Country practices: fiscal instruments targeting economic rents or windfall profits
- Many countries with fossil fuel extraction already have upstream fiscal instruments targeting economic rents with flat or variable rate structures (examples cited in text: Norway special petroleum tax; progressive R-factor–based production sharing; rate-of-return-based instruments in Angola and Australia).
- Some countries vary income tax or royalty rates with commodity prices (examples cited: Canada, Nigeria, Trinidad and Tobago).
- Examples of additional taxes: supplementary charge and energy profits levy in the United Kingdom.
- The United States is noted as having a fiscal regime less responsive to surges in profits.
- Several European countries introduced or announced temporary taxes or fiscal mechanisms to capture windfall profits (mostly targeting electricity sector; one case fossil fuel extraction):
  - Greece: Imposed a 90 percent levy on windfall profits of domestic power producers for the period October 2021–March 2022.
  - Hungary: Announced a temporary windfall tax for 2022 and 2023 on “extra profits” from energy companies; in the energy sector the tax applies on revenue generated from the difference between world market oil prices and actual prices paid on imports of oil products from Russia with a 40% tax rate (the rate was 25% until the end of July 2022).
  - Italy: Introduced a one-time 25 percent tax on energy companies (producers and sellers of electricity, natural gas, and petroleum products). The tax applies to company profits that rose more than €5 million between October 2021 and April 2022 compared with the same period in the previous year.
  - Spain: Announced a temporary windfall profits tax for extraordinary profits earned in 2022 and 2023 by electricity utility companies.
  - Romania: Introduced an 80 percent windfall profits tax on additional revenue realized by electricity producers calculated on the monthly difference between the average selling price and 450 lei per megawatt hour; the tax was subsequently modified to apply to net revenue, taking account of costs. The government also adjusted the fiscal regime for natural gas, introducing a progressive tax of 15 percent to 70 percent on additional income on gas prices above 85 lei (about $18) per megawatt hour.
  - United Kingdom: The energy profits levy, introduced in July 2022 and set to expire by the end of 2025, is an additional 25 percent tax on oil and gas profits on top of existing taxes, taking the combined rate to 65 percent. Previous losses or decommissioning expenditure cannot be offset against profits subject to the levy. To encourage new investment, there is an additional 80 percent investment allowance. The levy does not apply to electricity generation.
- European Commission guidance (EC 2022, Annex 2) on temporary windfall profits taxes for electricity generators requires that such taxes be temporary, preserve market signals (not increase marginal costs), discriminate based on generation technology, and use clear and verifiable criteria for determining “excessive” rents.

### Evaluating petroleum fiscal regimes (FARI framework analysis)
- Analysis uses the Fiscal Analysis of Resource Industries (FARI) framework (IMF 2022).
- Average effective tax rates (AETRs) for a selected group of large producers range from 35 to 90 percent.
- Jurisdictions with AETRs above 70 to 80 percent when prices are high (for example, Norway and Saudi Arabia) collect a large portion of project profits and have no basis for imposing new taxes in response to windfalls.
- Countries with AETRs (far) below 70 percent (for example, Mexico, United States, and United Kingdom before introduction of the energy profits levy) generally do not have robust rent-targeting mechanisms in their fiscal regime.
- Introduction of the temporary energy profits levy makes the United Kingdom petroleum fiscal regime less of an outlier.

### Progressivity, short-term revenue responsiveness, and breakeven price
- Fiscal regimes relying on profit-based mechanisms have relatively stable AETRs across different profitability outcomes because the tax base (and sometimes the tax rate) grows as prices increase; regimes with higher royalties and no excess profit taxation have declining AETRs because pretax profit grows faster than the tax base.
- Fiscal regimes including a progressive instrument result in more stable outcomes as prices change and greater certainty for investors.
- Short-term response of government revenue to a price shock generally mimics progressivity: higher short-term response (higher elasticity) means the government takes on a larger portion of short-term commodity price risk.
  - Fiscal regimes with profit-based mechanisms tend to have larger immediate changes to revenue (examples: Algeria and Norway).
  - Royalties and indirect taxes are less responsive because the tax base change is less pronounced.
- Breakeven price insight:
  - Taxes independent of profit levels generally result in higher breakeven prices because they apply regardless of project profitability (examples: carbon taxes in Norway and Canada; royalties in most countries).
  - Taxes targeting economic rents are non-distortionary and should not prevent investment.
  - Example: Norway’s AETR is ~85 percent compared with ~40 percent for offshore US projects, yet the breakeven price is only $5 per barrel higher because Norway’s excess profits tax increases government take when prices are high but imposes only a small or no burden on less-profitable projects.
  - Note: investor minimum return is assumed to be 13 percent in real terms in the breakeven price analysis.

### Annex summaries
- Annex 1 (Methodology): Country-level impact of recent oil, gas, and coal price increases is estimated at an aggregate level for consumers and producers using 2019 production and consumption levels (with an adjustment for Russia). Producer price increases use the difference between the average price from March 2021 to July 2022 and the average price for 2019 for exported production; domestically consumed production is valued at the change in domestic retail prices. Government revenue increases are estimated using average effective tax rates from the FARI model (or world average if missing). Consumer impact uses observed consumer prices or estimates from historical relationships (Amaglobeli and others 2022).
- Annex 1 (Windfalls by country): Combined gains for producers and governments of several large fossil fuel producers exceed 10 percent of GDP; gains are generally largest for natural gas producers, especially those selling into European markets. The gain to producers and government offsets the consumer loss in almost all cases (exception: India).
- Annex 2 (International Oil Company Profits): Largest oil and gas companies saw increases in profitability in Q1 2022; upstream segment drove profits through early 2022, with some shift toward refining and downstream contributions in Q2 2022 though exploration and production remained significant profit drivers.

*Source: Box 1. Comparison of Increased Pre-tax Retail Prices and Crude Oil Prices (insea2022002).*

### Annex Figure 2.1. Large Oil and Gas Company Profitability

### Annex Figure 2.1. Large Oil and Gas Company Profitability

### Return on equity (percent)
- Figure reports return on equity (percent) for large oil and gas companies (chart not reproduced here).
- No numerical ROE series are provided in the text excerpt.

### Net income, quarterly average (billions of US dollars)
- Figure reports net income, quarterly average (billions of US dollars) for large oil and gas companies (chart not reproduced here).
- Saudi Aramco excluded from the net income chart due to very high income: "$10 to $39 billion quarterly average in each year."
- PetroChina and Saudi Aramco had not reported their second quarter 2022 earnings at the time of the analysis.

### Data sources and notes on the profitability figures
- Source: S&P Capital IQ database.
- Note: Saudi Aramco excluded from net income chart for the reason above; PetroChina and Saudi Aramco missing Q2 2022 earnings at time of analysis.

### Annex 3: Fiscal regimes for comparator countries — key findings relevant to government take and investment incentives
- All modeled countries apply corporate income tax to the extractive sector.
- Mixed use of royalties and rent-targeting taxes across modeled countries.
- Seven countries have royalties, with rates ranging from five to 50 percent.
- Three countries have royalty rates that vary with commodity prices (Canada, Mexico, Saudi Arabia).
- Seven countries have rent-targeting taxes with varying designs:
  - Three allow for additional deductions to capital (Norway) or all expenses (Brazil and Kazakhstan).
  - Two are cash flow taxes with uplift on losses (Australia and Russia).
  - Algeria has a tax rate increasing with the R-factor.
  - The United Kingdom provides a surcharge on the corporate income tax base but without a deduction for interest.
- Five countries have significant equity interests; all modeled equity interests are assumed to pay their share of exploration costs (conclusive information not available for Algeria and Kazakhstan).
- Modeled regimes are intended to capture the design applicable to most existing projects; they may not reflect the most recent statutory structure (examples: Nigeria 1993 PSC and Saudi Arabia 2017 concessions modeled rather than 2021 Petroleum Industry Bill and updated royalty rates).

### Annex Table 3.1 and accompanying technical notes — modeling and definitional points
- Source for regimes: IMF, Fiscal Analysis of Resource Industries (FARI) library.
- Abbreviations and notes used in modeling: DB = declining balance; DROP = daily rate of production; EPL = daily rate of production; EPL = excess profits levy; NA = not applicable; prod. = production; PSC = production-sharing contractor; SL = straight line.
- Specific footnotes summarized from table notes:
  - Royalties are reduced by 50 percent for domestic sales. There is an additional export tax of 0–32 percent depending on the oil price.
  - Includes the 15 percent branch profit tax.
  - A non-price-based component of the royalty is biddable and assumed to be 10 percent. The Mexican regime reflects that of the 2017 bid round 2.4.
  - Multiple regimes in Russia; the latest regime with the adoption of the resource rent tax (called the AIT) is modeled.
- Further modeling notes:
  - DROP = daily rate of production; DWT = dividend withholding tax; EPL = excess profits levy; IRR = internal rate of return; IWT = interest withholding tax; NA = not applicable; PSC = production-sharing contract; SWT = state withholding tax; USD = US dollar.
  - Value-added tax is not included as all modeled countries are assumed to provide timely refunds on exports and not exempt major business inputs.
  - Withholding tax rates represent the lowest available rates provided through a country's tax treaties.
  - CO2 eq = carbon dioxide equivalent with methane converted to CO2 equivalent using a 100-year time horizon.
  - Applies only to nonresident subcontractors in most cases.

### Implications highlighted in the annex text
- The full structure of fiscal regimes and interactions between individual mechanisms are important because they ultimately determine the government take and the impact of fiscal policy on investment decisions.
- Looking only at progressive (or distortive) elements can result in misleading assessments of overall government take and investment impact.
- Modeled regimes choose representative legacy contract designs to reflect the fiscal terms applicable to most existing projects rather than the most recent statutory changes.

*Source: S&P Capital IQ database; IMF, Fiscal Analysis of Resource Industries (FARI) library.*

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_Source: https://www.imf.org/-/media/files/publications/imf-notes/2022/english/insea2022002.pdf_