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Norway’s fiscal stability comes under strain

The country faces challenges to the much-vaunted tax regime certainty on which it has built exploration success

Norway's 78pc tax rate on income from hydrocarbon production is steep by international standards. But the country has always stressed the stability of its fiscal regime and its balance and neutralitywhere the government shares a significant amount of the risk in return for its big take on the reward and the drill/no-drill decision is not impacted by tax concerns-as attractive to explorers.

That stability and neutrality is now coming under increased strain. In part, the pressure is from a more aggressive Norwegian environmental lobby, which is targeting specific elements of the tax code to further its agenda of reducing activity on the Norwegian continental shelf (NCS). But elements within the finance ministry, which argue for a lower net present value (NPV) discount rate and a subsequent lower rate of uplift allowance, also pose a risk.

Most Norwegians remain content with building on the country's base of extensive hydro-electric power generation to pursue a green domestic agenda, including some of the most ambitious targets globally for electric vehicles. All the while, Norway continues to enjoy the economic benefits accruing from its large-scale hydrocarbon exports.

But there is a Norwegian environmental lobby that wants to go significantly further, aiming to reduce NCS activity and cut Norway-produced exports' supply to their destination markets. The Christian Democratic party, or KrF, while still primarily focused on a conservative social agenda, has adopted a harder line green policy. While it has just eight parliamentary seats, making it the seventh-largest part in the Storting, it has played a role bigger than its representation, due to Norway's ruling coalition initially being a minority government.

The KrF previously lent votes to the coalition but, following an internal party vote in November, in early January it entered negotiations to formally join the current three-party coalition and give it a majority. Post-vote, the KrF raised cutting Norway's uplift allowance as a potential price of entering government, although prime minister Erna Solberg made it clear that was not on the table, says Espen Erlingsen, head of upstream research at Oslo-based consultancy Rystad Energy. Indeed, it was a compromise over abortion, rather than oil, that finally sealed the KrF joining a new majority coalition on 18 January.

But, going forward, although the two largest governing partners, the centre-right Conservative and Progress parties, are firmly pro-oil and gas, the KrF's addition to the government could embolden fellow junior partner the Liberal Party to become more vocal on the environmental agenda.

Economic standpoint

And, within the finance ministry, there is also a faction arguing the current 5.2pc (20.8pc over four years) special tax uplift allowance is too high, although based on economic theory, rather than environmental grounds, according to Graham Kellas, senior vice-president for fiscal research at consultancy Wood Mackenzie. The uplift allowance is intended to compensate oil and gas producers for the net present value (NPV) lost as a result of depreciating capital costs over 6 years for tax purposes. This is linked to the government's well-established policy objective of tax neutrality in investment decisions.

The finance ministry faction argues that the discount rate used to calculate the NPV lost as a result of depreciation should be a risk-free rate (c. 2pc). If this was the case, the uplift rate could be much lower than it is today (20.8pc) and still achieve tax neutrality. The industry, however, contends that the NPV calculation should reflect the discount rates they normally use, as they do not discount tax allowances differently from other elements of the cash flow. Globally, upstream discount rates are usually in a 10-20pc range with a mean around 15pc and, on that basis, Norway should actually be increasing the uplift rate in order to meet its objective of tax neutrality in drill/no drill decisions, says Kellas.

Another key plank of the Norwegian fiscal system-the refund of 78pc of exploration costs directly in cash to NCS firms without an existing tax base to receive a rebate in offsetsis also under threat from an environmental lobby. The European free trade agreement (Efta) surveillance agency (Esa) is looking into a complaint from Norwegian green group Bellona that the refund is a subsidy rather than a tax allowance, and thus constitutes illegal state aid and must be rescinded. An Esa decision may arrive in the second half of 2019, estimates Rystad's Erlingsen.

Refund defended

The introduction of the cash refund for firms without tax offsets is a "success story for Norway" that has driven a significant increase in exploration, says Erlingsen. Its potential removal is a "concern" for future NCS exploration as it could represent a barrier for entry for smaller new entrants and existing minnows compared to the current regime.

The Norwegian finance ministry is putting up a spirited defence of the refund, arguing that it cannot be taken in isolation from the NCS fiscal regime in its entirety. In essence, its contention is that, if the refund was not on offer to explorers without a taxable income against which to offset, the tax regime as a whole would be discriminatory, in sharp relief to Bellona's micro-focus on the cash refund as preferential to non-producers versus producers.

Wood Mackenzie's Kellas takes no view on the legal arguments around whether the refund breaks Efta state aid rules. But the firm's analysis refutes the green lobby's more philosophical argument that the Norwegian state is subsidising oil explorers with no return to the public purse.

By the law of exploration industry averages, only one wildcat well in every four or five makes a commercial discovery, and thus the Norwegian state is paying 78pc of costs on these 75-80pc wellseither in cash or taxable income offsetsthat it will not get back. But the wells that do result in discoveries pay back "significantly more" in tax on their production than the state pays out in exploration costs, generating a "perfectly reasonable return on capital, in fact often above the return from investments made by the sovereign wealth fund", says Kellas.

Tax rate adjustment?

As well as discouraging prospective new entrants and current explorers without an income stream, a ruling against the scheme could add complexity that Norway, which trumpets the relative simplicity of its fiscal regime, would prefer to avoid. Non-producing explorers rarely hold production licences (PLs) in their entirety but have partners who do have taxable income from production. A regime where the latter could immediately claim back 78pc of exploration costs against their tax liabilities, but the former would not be compensated until such time as they might have a taxable revenue stream, is a recipe for increased drill/no-drill decision conflict within individual PLs.

In the event of an unfavourable Esa decision, Norway could look at recalibrating the risk-reward balance for affected NCS explorers by looking at adjusting the 78pc tax rate of production income, although Kellas expects pushback on such a move. For one thing, a cut in, or even full removal of, the 56pc special tax that tops up the country's 22pc non-oil corporation tax to 78pc would not be applied retrospectively, nor, in all likelihood, to substantial future findsbreaking Norway's cherished fiscal uniformity.

But the increasing maturity of the NCS-in particular, with notable exceptions such as Johan Sverdrup, the smaller average size of discoveries-may require Norway to introduce some variation into its fiscal regime to maximise recovery. Kellas suggests that it may be possible to make tweaks to the special tax which would have a minimal impact for a 2bn-bl discovery but substantial positive implications for a marginal 10mn-bl find. The holy grail is to discover an approach that will incentivise development of a growing number of smaller deposits without introducing the tax complexities that dog other basins such as the UK continental shelf.

Despite the potential challenges posed by these environmental, political and geological challenges, neither Rystad nor Wood Mackenzie is downbeat about NCS exploration and production in the near future. Erlingsen sees the main threat posed not by the likelihood that the fiscal regime will change significantly, more than the possibility of changes introduces unwelcome uncertainty in contrast to previous investor confidence.

And Kellas points to "very high" exploration drilling activity and a good pipeline of plans for development and operations as evidence that the NCS remains in relatively rude health.

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