UK aims to kick-start British shale revolution

The government has proposed a shale-specific tailored tax regime to encourage development

Michael Thompson and Nick Connell,
Vinson & Elkins,
London

What a difference a year makes. In the summer of 2012 shale gas exploration in the United Kingdom was subject to a moratorium following earth tremors allegedly linked to drilling in Lancashire, North-West England. Prior to that, shale exploration had been met with caution from the UK government and strong opposition from environmental and local action groups.

Now, a year later, not only has the UK government brought the moratorium to an end, but has taken active steps to kick-start a British shale revolution. Rising domestic energy prices, a flat-lining economy, diminishing production from the North Sea, and encouraging reports of reserves (and a few jealous glances across the Atlantic) have persuaded the UK government finally to embrace shale.

How will the UK encourage investment in this fledgling industry? How does it plan to handle the competing dynamics of encouraging investment, generating tax revenue, and addressing the still active concerns of local communities?

The main measures currently being considered by the government can be divided into three categories:

• A tailored tax regime;
• Planning and regulatory reform; and
• Local community benefits.

A tailored tax regime

Oil and gas tax in the UK

There is already a well-developed tax regime for oil and gas activities in the UK and on the UK Continental Shelf (UKCS). The regime, which has historically focused on the North Sea, has three principal elements: (i) Ring Fence Corporation Tax (RFCT); (ii) the Supplementary Charge (SC); and (iii) Petroleum Revenue Tax (which is being phased out and will not be relevant for the purposes of new shale gas exploration).

RFCT is similar to standard corporation tax, but is at a higher rate (currently 30% as opposed to 23%) and applies to "ring fence" activities, namely oil and gas extraction in the UK and UKCS. It is ring fenced because the tax liability cannot be reduced by losses from other non-UK oil and gas activities. SC (currently 32%) is calculated in the same way, but with no allowance for financing costs. Together, they create a combined tax rate of 62%.

Since the unexpected tax raid on the North Sea in 2011 by George Osborne, the UK Chancellor of the Exchequer, which increased SC from 20% to 32%, companies have been wary about the government's long-term commitment to encouraging investment in the energy sector. However, the government has since worked quite hard to reassure the industry of its commitment to a stable and attractive regime.

Approach to shale gas

In relation to the tax regime for shale gas production, there have been calls within the industry for the UK government to avoid cashing in too early. Francis Egan, CEO of Cuadrilla Resources Ltd. (one of only two companies to have drilled shale wells in the UK so far) has said that: "If allowed to grow up into a tax-paying adult, [the UK shale gas industry] will pay a lot of tax, but it is in its infancy and there is a concern that that infant could be strangled at birth."

Perhaps with this in mind, Osborne, in his 2013 budget, announced two shale-specific innovations: a new field allowance for shale gas and the extension of the Ring Fence Expenditure Supplement.

New field allowance

Essentially, the intention is that taxation of shale gas will fall within the scope of the existing ring fence regime (and therefore be subject to RFCT and SC). This regime already gives tax relief to companies who are operating in certain types of fields, which are economic but commercially marginal or challenging. These allowances provide that a certain fixed amount can be taken off the profits made in the relevant field to reduce the SC payable.

For the new shale gas allowance, it is anticipated that the focus will be on the location at which the drilling takes place (the pad) rather than apply to the entire licensed area. The logic behind this is to avoid a definition of a shale "field," which could be either too broad (and inadvertently apply to non-oil and gas producing activities) or too narrow and technical (and prevent genuine shale gas exploration from benefiting).

The current intention is that the amount of this "pad allowance" will be a percentage of the company's actual capital expenditure relating to the pad rather than a fixed amount. A company's allowance would increase annually as additional capital expenditure is incurred and this allowance would be available against the company's ring fence profits generally and not restricted to profits from the particular pad that generated the allowance or only its profits from shale gas production.

It has been suggested that once production income is generated, there may be a limit on how much of the allowance can be used in one tax year. However, some concern has been expressed that such a limit may be unsuitable for shale gas development, which can have a longer period of exploration but only a short intense period of production. If, for example, only 20% of the allowance can be used to offset production income in one year, and a company only has production income for two or three years, it will be prevented from fully benefiting from the allowance.

The precise terms of this new allowance will be announced following a public consultation (to be launched later this summer).

Extension to ring fence expenditure supplement

For companies carrying out ring fence oil and gas exploration, the impact of capital allowances (which allow capital expenditure to be offset against income profits) is further boosted by the Ring Fence Expenditure Supplement (RFES). The RFES increases, for a limited number of years, the value of certain unused allowances to take account of the delay between the incurring of the expenditure and the receipt of income from production. The specified percentage increase is currently 10%.

Here the UK government has appreciated the longer investment period, which is characteristic of shale gas projects, and has announced it will extend the usage period of RFES for shale gas exploration from six years to 10 years.

Planning and regulatory reform

The onshore oil and gas planning and regulatory regime has obvious differences in emphasis compared to its offshore counterpart and also has received less attention from lawmakers in the past 50 years.

While it is recognized by industry representatives that the regime as a whole does not appear at this early stage to be too lax or overly demanding, it is widely agreed that the application process is not investor-friendly. Indeed, a company wishing to drill an exploratory well in the UK has to seek regulatory permissions from four separate agencies: the Department of Energy and Climate Change, the Health & Safety Executive, the Environment Agency, and the Local Mineral Planning Authority.

The cumbersome nature of this process is compounded by: (i) the fact that the latter two permissions require public consultations; (ii) the overlap in some of the assessments; and (iii) the fact that each agency submits its own guidance on shale gas operations. This has led to uncertainty for investors who have called for the regime to be streamlined and for an adoption of the United States' "let's get it done" approach.

In response, the UK government has established the Office of Unconventional Gas & Oil (OUGO), which will provide investors with a single point of contact and simplify the application process.

Guidance on how the current planning and regulatory regime will interact with shale gas operations will be published this summer, but the UK Government has suggested that any radical change in the planning rules will probably not occur until the shale gas industry has further developed.

In the meantime, the re-formed UK Onshore Operators Group, which represents the UK onshore oil and gas industry, has published the UK Onshore Shale Gas Well Guidelines, which contain what is considered to be good industry practice and references to relevant legislation, industry standards and practices. They supplement the existing Oil and Gas UK Guidelines to cover areas unique to shale gas wells and high volume fracturing operations. The guidelines are seen as a message to the UK government that the industry will take regulation of shale exploration seriously.

Local community benefits

A key consideration for the government is the reaction shale gas exploration receives from the local population. The Extreme Energy Action Network has led vocal opposition campaigns to UK shale gas projects. It is clear that companies will need to be sensitive to the concerns and needs of local communities.

Unlike in the US where it is generally the case that mineral rights belong to the landowner, in the UK all mineral rights belong to the Crown. Therefore, the main potential benefit for a local population of allowing shale gas activity in their area – a contractual share in the profits through royalties – does not exist in the UK.

In its latest report on shale gas in the UK entitled The Impact of Shale Gas on Energy Markets, Seventh Report of Session 2012-2013, the Department of Energy and Climate Change has suggested ways in which companies developing shale gas can interact with local communities.

Although OUGO will take the lead in reacting to scare stories and misinformation, companies themselves will be expected to be proactive and engage with local communities from the beginning to minimize any potential issues.

Further, there is agreement among companies and the UK government that local communities should receive tangible benefits as compensation for the disturbance caused by any development. A recently announced proposal is that exploring companies will provide £100,000 (about US$153,000) in community benefits per well-site where hydraulic fracturing occurs and, during the production stage, pay 1% of revenues to the communities that host them.

Looking ahead

The true value of the UK shale gas industry remains to be seen. The British Geological Survey has recently published a report, which estimates that the total volume of gas in the Bowland Hodder shale in northern England is 1,300 trillion cubic feet. However, it will not be until further exploration drilling takes place that its true prospects will become clear. The UK government hopes that the measures it puts forward this summer will make up for lost time and entice investors to take those crucial first steps to kick start a British shale revolution.

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