Tax on windfall low-carbon profits Catch 2: The tax on electricity generators | Allen & Overy LLP
The Chancellor’s Autumn Statement announced the introduction of a new exceptional 45% tax on the “extraordinary profits” of low-carbon electricity producers, via the Electricity Generator Levy (the Generator Levy).
The structure of European energy markets – where the marginal cost of the most expensive form of generation needed to meet demand determines the market price – means that high gas prices have created additional profits for some forms of generation versus generators who have to buy fossil fuels to generate electricity. While the substantial overhaul of the electricity market in Britain promised by REMA (on which the consultation closed last month) will aim, in part, to deal with the market consequences of major external shocks such as that caused by the invasion of Ukraine, the redesign and its implementation is not simple and therefore will inevitably take time. In the meantime, the government has estimated that low-carbon producers should contribute some of their additional income to public finances and support households and businesses through the current cost of living crisis. The Generator Levy is expected to bring in around £14 billion to the public sector over its lifetime.
The generator tax is to replace the Cost-Plus revenue limit (envisioned by the previous government as an effective cap on revenue from certain low-carbon generation) which was contemplated by the Energy Pricing Act, which was enacted last month – see our previous comment on this here.
Range and mechanics
The generator tax is described as a temporary measure that will apply to production between January 1, 2023 and March 31, 2028, regardless of when the sales contracts were entered into.
The generator tax will be applied to groups of companies producing electricity in the UK from renewable, nuclear and biomass sources. It will not apply to pumped hydro or battery storage and will not include revenue from the sale of ROC or capacity market payments.
‘Extraordinary profits’ are defined as the revenue (not profit) from electricity sold above £75/MWh (based on the aggregate revenue that a group of producers realizes during the relevant period at from in-scope generation at an average generation price above £75/MWh). MWh). Nothing has yet been said about the indexation of this threshold.
The average revenue per (accounting) period must therefore be greater than £75/MWh to trigger the charge. The government has said it considers there should be a provision for balancing and financial hedging costs (although details are not yet available), but otherwise this is structured as an income tax and not on profits. If unfairness to producers is to be minimized, language will need to be carefully crafted so as not to unfairly penalize groups’ hedging or trading strategies.
The tax will be limited to generators whose in-scope generation output exceeds 100 GWh over the relevant period and will then only apply to such “extraordinary profits” to the extent that they exceed £10 million.
Like the current Energy Profits Tax applicable to oil and gas producers (the scope and duration of which are to be extended under the same package), the Generator Tax will be administered by the through the corporate tax system – the tax is levied on a corporation as if its amount were an amount of corporation tax payable by it. The relevant calculation period will be aligned with the accounting period of the company in charge of managing the direct debit for the group.
Groups of consolidated companies
The Generator Levy therefore considers groups of companies on a consolidated basis. This is a significant change from the Energy Pricing Act’s approach, which focused on the individual producer (who might not have realized the market price due to hedging agreements). This change in approach adds a level of complexity that will require careful consideration to ensure it works without unintended consequences.
Where a group’s output is sold to third parties, the measure of revenue will be the revenue received from the third party by the relevant group member (regardless of whether it is ultimately sold by the producer). The treatment of intra-group consumption should be considered.
For energy companies that cover generation and supply, revenues related to final consumer supply will need to identify the relevant components of those revenues. Obviously, any misalignment between the entity responsible for the levy and the recipient of the revenue raises the prospect of cash flow problems for producers. There may also be time lags, depending on when revenue is recognized. We anticipate difficult questions regarding when the group monetizes electricity – for example, a group should not be allowed to trade in-scope electricity with another group at below-market prices, in order to keep the “realized prices” for its own production low.
It is recognized that production joint ventures may require special consideration (particularly where production is sold to stakeholders) – again, careful language will be required here for this to work as intended.
Groups with different minority investors in their generation assets may also face tax allocation issues.
The generator tax will not apply to electricity generated outside the UK and imported (but it will apply to electricity generated in the UK and exported).
It is stated that the producer tax will not apply to electricity “generated under a contract for difference” (where the producer reimburses the public sector for generation revenues above the applicable strike price) .
This wording may imply that generation by CfD holders prior to the start date under it will be subject to tax, which may raise an interesting debate around the scope of the law change protections and generation tax in the CfD.
The proposed exemption for CfDs may be an additional incentive for generators to enter into the “pot zero” CfDs contemplated under the Energy Prices Act.
Scope of the challenge
A side effect of structuring the measure as a tax under an Act of Parliament itself means that it will, in principle, be less likely to be challenged by judicial review than if the Secretary of State exercised the powers conferred on him. This may also impact any potential claims under the Energy Charter Treaty.
Continued investments in the sector
The government expresses the hope that the “temporary and proportionate” levy should not harm long-term investment as it only applies to part of the additional returns and electricity producers can still deduct the corporate tax investment. That remains to be seen. Critics will say the impact on cash flow itself can hamper the appetite for reinvestment. Unlike the Energy Profits Tax, where oil and gas producers can receive specific tax relief for reinvestment in the sector, there is no specific relief offered by the Generator Tax for reinvestment in new projects.
As noted earlier, investors able to make comparisons between the UK and EU investment landscapes for low-carbon generation will notice that the revenue cap for license holders EU for renewable energy generation (which applies as an effective cap rather than a levy on excess revenue) is set at 180 EUR/MWh. This will no doubt contrast unfavorably with the much lower level at which the generator tax begins to apply.
The Treasury has not provided detailed justification behind the £75/MWh threshold beyond stating that the level is significantly higher than the average wholesale price of electricity over the decade to 2021. The Energy Pricing Act did not indicate the threshold – it was to be left to delegated legislation.
The details of the tax on generators will be defined in the finance bill. A draft of the relevant legislation is expected in mid-December.
Producers will want to carefully consider the position set out in the bill when it is released.
The Treasury said it would contact affected producers to discuss the implementation of the generator tax, although discussions of previous approaches to this issue have already taken place. Given that the bill is expected to be released in a few weeks, growers will need to react quickly.
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