Otto Brøns-Petersen // 9 November 2022

At first glance, the EU Commission’s suggestion that above-normal returns in the energy sector be taxed may seem like a reasonable and timely initiative. A so-called windfall tax could be used to disconnect electricity prices from high gas prices, and the tax revenue could be distributed to consumers who suffer from high fuel costs. The reasoning is that is that this would kill two birds with one stone in the soaring cost-of-living crisis.

Contrary to other means of taxation, a true windfall tax would not reduce the incentives for making new investments, which may have negative behavioural effects on the market. However, such a tax is a serious delusion. A windfall tax would increase long-term electricity prices for consumers – it could either fail to bring money into the treasury or permanently damage the energy sector. Any discount on electricity prices by disconnecting it from the natural gas price will eventually be paid by consumers. Unfortunately, European politicians are eager to give the impression of ‘doing something’. So, hold on to your hat and keep an eye on your wallet!

The first requirement for a successful tax on ‘excess profits’ is that there should actually be an above-normal return in a sector – not merely fluctuations from year to year but continuous and systematic above-normal returns. The prerequisite for systematic above-normal returns is scarcity in a given sector, which cannot be reproduced. Otherwise, the high returns will attract new producers until the high returns return to normal. Keep in mind that it is not only politicians but also competitors who yearn for higher returns on investments. However, this still requires that the product be reproducible.

In some cases, scarce, non-reproducible factors do exist. The deposits of oil and gas in the North Sea are an example. Since competitors in the region cannot acquire a good oil or gas field, countries around the North Sea employ special hydrocarbon taxes, which act as a replacement tax on above-normal returns.

But electricity production, as such, is not bound by a non-reproducible factor. Therefore, there are no systematic above-normal returns to tax. These are good times for power producers, but at other times, it is the other way around.

Taxation scenarios

If an attempt is made to levy a windfall tax on the energy sector, it could, in principle, be designed in one of the following ways.

Variant 1. One could settle for a one-off tax with reference to ‘extraordinary circumstances’. If investors trust that such a tax will not be repeated, it would not affect their future investment calculations – i.e., it would have no negative behavioural effects.

However, this is just not realistic. Once a state levies one-off taxes, it may find it easier to do so again, and each time, it would have less and less reputation to lose by doing so. Therefore, the returns requirements for energy investments will be higher, driving up the prices further. One example of this is the United Kingdom, were successive governments have introduced windfall taxes several times.

Variant 2. Another way is continuous taxation in all years with ‘above normal’ returns. An asymmetric tax on only the upside will also have a distorting effect and increase the average return requirement. Less will be invested, less electricity will be produced, and consumers will pay higher prices.

In principle, you can implement both variants by introducing price caps instead but with the same consequences at best. Neither of the two variants is a neutral tax on above-normal returns. A neutral tax will require provision for deductions in years with subnormal returns – in the worst case, producers will have to be reimbursed by the state, which is approximately how the North Sea taxation is structured.

The problem is simply that, unlike in the North Sea, there is no systematic above-normal returns on electricity production in the EU. A tax on electricity would not generate any surplus revenue over a period of years. The main effect will be that the state will take the risk of energy production. The energy companies’ expected average earnings will be the same, but the fluctuations will be smaller.

In practice, however, there are significant problems with designing and administering a tax on abnormal returns and significant risks of tax speculation. North Sea taxation is filled with special rules to protect against these kinds of issues.

The big question is: even if a neutral tax does not bring in any revenue over time, could it not be used to equalize the price of electricity? The proceeds generated in years with high electricity prices could be used to lower the electricity price, and, correspondingly, with low prices, the tax and subsidy could reach negative within years. If the slogan ‘disconnecting the price of electricity from the price of gas’ is to make any sense, it could be done with such a model.

Levelling the price is not without costs

Equalizing electricity prices may sound enticing, but it comes at a cost. Since it will shift electricity costs from years with high prices to years of low prices, it will require the average electricity price to be higher. In this case too, electricity customers end up with a higher total bill.

In effect, the state would establish a mandatory insurance scheme. For some consumers, insurance against fluctuations may be a good idea but a compulsory government scheme is not. It is already possible to insure yourself on market terms. Many electricity companies offer subscriptions with fixed prices, and there are financial products that provide just that service. If people want to secure themselves for the future, there is no reason why private insurance products cannot be designed to meet that need.

Taxes on abnormal profits and lower electricity prices are like the call of the siren; Consumers and voters would do well to shut their ears.

The Danish original was published by CEPOS and translated and edited by Henrik M Nielsen.