Energy Transition

How windfall taxes could bolster efforts to reach net-zero

Truss towers around sunset: An alternative to windfall tax – redistributing some profits into net-zero investments.

An alternative to windfall tax – redistributing some profits into net-zero investments. Image: Unsplash/Matthew Henry

Aaron Yoon
Professor of Accounting & Information Management, Kellogg School of Management, Northwestern University
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  • There are growing calls for energy companies to pay windfall taxes on excess profits as rising energy prices contribute to a cost of living crisis.
  • One alternative approach to windfall taxes is to compel companies to reinvest some excesses into alternative energy projects to boost their value.
  • Redistributing profits into alternative energy projects carries societal benefits, but it also relies on companies to execute this redistribution, calling for trust and accountability mechanisms.

The spike in global petroleum prices in 2022, with oil topping $120 a barrel and gasoline prices in the United States exceeding $5 per gallon, has escalated demands for windfall taxes to be levied on petroleum companies. Among the most vocal are United Nations Secretary-General António Guterres, who has urged “all developed economies to tax the windfall profits of fossil fuel companies”, and Governor Gavin Newsom of California, where gas prices are well over $6 a gallon, who tweeted, “We’re not going to stand by while greedy oil companies fleece Californians.”

Windfall taxes, by definition, aim for excess profits generated by supply disruptions and macro events. The Crude Oil Windfall Profit Tax Act of 1980, enacted during OPEC oil supply disruptions, provides a definition and historical context. It defines a windfall profit as the “excess of the removal price” for a barrel of crude oil (meaning, the price for which it is sold) over an inflation-adjusted base price. In simplest terms, windfall taxes can be reduced to a cause and effect: when a supply shock generates abnormal or unusual profits, governments levy taxes that redistribute wealth from energy companies to people.

Current calls for windfall profit taxes are in reaction to the spike in oil company profits due to supply disruptions caused by the Ukraine War and Russia’s manipulation of energy supplies. Higher energy prices have also contributed to skyrocketing inflation that continues to push up the cost of goods and increases the economic burden on low-income consumers.

Even among oil industry executives, a windfall profits tax is widely regarded as inevitable. Shell CEO Ben van Beurden, speaking at the Energy Intelligence Forum in London recently, commented: “One way or another, there needs to be government intervention that somehow results in protecting the poorest. That may mean governments must tax people in this room to pay for it.” A Shell spokesman later clarified his comment as referring to companies, not individuals.

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Windfall profits and net-zero investments

There is, however, an argument to be made for allowing energy companies to keep some excess profit to fund short-term investments in alternative energy to combat climate change.

Many countries, businesses and other entities have pledged support for net-zero emissions. The energy industry is at the nexus of this change because of the need to transition away from a fossil fuel economy to renewable energy sources. The International Energy Agency observed: “[The] gap between rhetoric and action needs to close if we have a fighting chance of reaching net zero by 2050…. Doing so requires a total transformation of the energy systems that underpin our economies.”

Such transformation requires capital, which could be satisfied in the short term if the oil and gas industry channels excess profits into next-generation energy sources and technologies. Until recently, the oil and gas sector has been under pressure from an investment standpoint.

For example, a popular strategy among many fund managers, until recently, was taking a long position in technology stocks – expecting them to increase in value relative to the benchmark index – and a short position on energy stocks – projecting their decline in value relative to the benchmark index. That this approach is adopted underscores the point that, until recently, energy has lagged behind other sectors, potentially making it less attractive from a capital markets perspective. That could impact energy transition.

Given this scenario, the case could be made that redistributing windfall profits into net-zero investments would carry significant societal benefits. The argument, however, is not without its caveats:

  • Trust in business or government? One of the deciding factors is whether governments or companies are seen as more trustworthy in distributing excess profits. Some may view it preferable for governments to give cash payments to individuals at or below a certain income level. While such money would offset increases in energy and other household expenses, there are other societal benefits to consider, particularly given the urgency of net-zero goals.
  • Execution is in the hands of companies. Climate change mandates will continue to come from governments. However, proper execution of those mandates will ultimately be the companies’ responsibility. For example, Shell has set a 2050 target for net-zero emissions (including Scope 3, which calls for the most intense efforts), with similar commitments from Equinor of Norway and BP. In addition, ExxonMobil has publicly expressed the company’s willingness to transform its operations.
  • Companies need to communicate commitment and progress. Given the high stakes of climate change and the well-recognized need for definitive action, energy companies must demonstrate their willingness and ability to channel profits into net-zero investments. That requires ongoing communication between energy companies and stakeholders, including regulators, environmental, social, and corporate governance investors, activist investors and other watchdog groups.

The objective of windfall taxes is not to punish but rather to redistribute gains in support of the greater good. In the current environment, enacting a windfall tax should be viewed in the context of establishing the right synergy between providing help to those at lower income levels while also ensuring investment in net-zero strategies. Getting this balance right would benefit society and the planet.

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