Partygate aside, the domestic news story currently dominating headlines in the UK is a possible one-off windfall tax on energy companies.
By hinting that ‘all options are on the table’ to tackle the cost-of-living crisis, the prospect of a government-imposed windfall tax – which just a few weeks ago looked remote – has become very real.
So, what does this mean for investors who are exposed to the energy sector?
Andy Merricks, fund manager at 8AM Global, argues that while the windfall tax sounds popular and fair, the potential unforeseen consequences support the government’s earlier hesitancy to act.
“It’s been said many times that it is far from certain how any revenue raised will find its way to the ‘right hands’ and, despite its name, how certain can we be that it will be a one-off?
“That said, it would be pretty unpalatable if shareholders were seen to benefit through any special dividends paid by the companies, although their relatively dependable dividend history has made them the bedrock of many a pension scheme.”
Merricks adds: “If a windfall tax affects [energy companies’] share price or risks the dividend, it could have consequences for many pensioners who are also those struggling with their energy bills.”
Darius McDermott, managing director at Chelsea Financial Services, agrees with Merricks that, on paper, a plan to ease the cost-of-living crisis inevitably gains traction at a time like this, but he believes a windfall tax to take money from listed companies sets a dangerous precedent.
He adds: “They are cyclical businesses and they are just having a good cycle. And would a windfall tax be a one-off or could it turn into ‘we’ll take 5% of your profits’ each year?”
As for impact on dividends, McDermott suggests that a windfall tax could be damaging. “Dividends come from cashflow, so yes dividends could be affected. Shell is down 1.4% at the minute – which is not a disaster. It is too early to say but we might see dividends cut, after all the windfall tax is not a certainty yet.”
Tax could impact green investment
One aspect of a windfall tax that has often been glossed over is that it would likely include wind farm operators.
Essentially, North Sea oil and gas producers are only half the picture, high gas prices have led to some pretty substantial profits for all electricity generators – including renewables.
This is something that McDermott picks up on. “Renewables would also be taxed at a time when the energy sector is in transformation. It sends the wrong message from an ESG perspective.”
McDermott explains that a whole host of wealth managers have exposure to London-listed wind power companies. He namechecks Greencoat UK Wind and The Renewables Infrastructure Group (TRIG) as firms in this space that have already seen their share prices fall.
There is also an argument that a windfall tax might be counterproductive as non-renewables – such as the oil and gas majors – are expected to finance part of the green transition. Could a tax undercut the push for investment in renewable infrastructure or will most of the transition investment come from others?
Merricks believes the part oil and gas mega caps need to play in funding future renewable infrastructure is generally underestimated and they can have a big role in achieving the move away from oil and gas.
“A windfall tax could have the exact opposite effect to what the ESG flag wavers are after. It’s been quite interesting to see how fund managers’ attitudes have changed towards the energy companies since they started making better returns than virtually any other sector in the stock market.”
He adds: “They have turned from being everyone’s ‘baddies’ to the poster children in support of rehabilitation. If they carry on making investors money, this will, to my cynical mind, have more than anything else to do with whether investors turn away from them. In the short term, a windfall tax won’t help their share price, that’s for sure.”
Andrew Bell, CEO of Witan Investment Trust, says the argument against a windfall tax rests partly on the benefits of having a predictable tax regime, so that companies can plan, and partly on the hope that a bargain can be struck for energy companies to invest in new capacity and in sustainable energy sources to help combat climate change and help bring prices down.
“One problem with this is that both will only have an effect in the long term, whereas the [cost-of-living] crisis is severe and immediate”.
Incentives to invest
A key point, Bell argues, is that if a tax is levied on the windfall element alone then companies can be given incentives to invest without undeservedly benefiting from prices elevated by factors that are unrelated to their own efforts.
He elaborates: “So if, for argument’s sake, $80 oil is the level at which companies would have incentives to develop new fields or invest in competing sustainable technologies then the excess, currently $30 or around 40%, could be taxed as a windfall without undercutting the economics of investing in new energy capacity.”
Taking a longer-term view, Bell believes fossil fuels will likely form a shrinking part of the energy pie and companies in the sector will be politically vulnerable to higher ‘carbon cost’ taxes from governments in energy-consuming countries, as well as oil producing countries capping their ability to benefit from rising prices.
“Some fossil fuel companies may successfully transform themselves to profitable sustainable energy companies but the business risks are higher than operating as they have in the past – not many buggy whip manufacturers became car companies.”
Bell concludes: “Instinctively it feels like obsolescence has been added to commodity-price dependence as a reason to be structurally wary of the fossil fuel sector. In the short-term, as in 2022, high prices and energy scarcity could drive strong performance.
“However, it seems that these will be opportunities within a trend of long-term decline so the stocks may prove less of a buy and hold for portfolios than in the past.”
