oil and gas subsidies

Last October, I wrote about the way that arcane statutory language on what tax breaks needed to be reported in Texas resulted in the largest tax subsidy to oil and gas in the state not being reported at all. Specifically, if a particular tax does not comprise 5% or more of the state's revenues, exemptions from that tax don't need to show up in the biennial Tax Exemptions & Tax Incidence Report. This exemption applies even if the revenue loss from the provision to the state Treasury is tens or hundreds of millions of dollars per year.

Oil and gas are often co-produced at the same wells, and tax breaks to one are often applied to the other in a similar way. Most states report the joint revenue loss from the tax break flowing to both fuels. Many states also focus on the scale of the revenue loss rather than the scale of the tax base in deciding what must be reported in their tax expenditure budget. The magnitude screen seems a good one, since if a provision is costing taxpayers $50 or $100 million per year it is reasonable to assume that state taxpayers would want to know about it.

In Texas, however, the oil and gas rules are in separate sections of the statutes. As a result, the reporting threshold for the oil production tax and the natural gas production tax are calculated separately. The result in many years has been to hide the very substantial revenue losses resulting from the natural gas subsidy.  

The good news is that the latest version of the Tax Exemptions & Incident report, released in February 2023, does include high cost natural gas. Table 10 from that report is shown here. 

It is likely that this change in reporting was the result of surging natural gas prices during 2022 driving the associated production taxes to exceed the 5% reporting threshold, rather than a recognition that regardless of that threshold the provision was still causing large enough losses that transparency should be provided. Earth Track has requested clarification on this from the Comptroller's office. 

However, because eligibility for the high-cost natural gas is driven primarily by technical attributes of the wells and not on whether the field is actually profitable, we see surging revenue losses to the state at the same time profits to oil and gas reached their highest levels in years. This is a particularly poor incentive structure.

And the cost to Texas taxpayers has been huge. The provision was expected to reduce production taxes on natural gas by nearly $1.4 billion in 2023, and $6.3 billion between 2023 and 2028. This adds to the $11.6 billion in subsidies to these gas producers between 2009 and 2022.

It is time to end this subsidy; for specific recommendations, see my October post.

The Joint Committee on Taxation of the US Congress has gradually posted many of its publications going back as early as 1926.  Special tax rules for natural resources were a focus of JCT's attention even in its earliest days.  By the mid-1920s, standard cost depletion had already been jettisoned for discovery value.  Under cost depletion, taxpayers could write off what they'd invested in the mining property.  Discovery value depletion introduced subsidization, as it allowed the write off of the value of minerals at the time of discovery, even if that value was more than the investment (as it normally would be, else the mine would be losing money).  The discovery approach proved difficult to implement because the minable reserves couldn't always be assessed ahead of time, so the tax code shifted to percentage depletion, allowing 27.5% of the gross value of oil and gas to be written off from taxes each year.  JCT was concerned about this from the outset:

The text below has a refreshing honesty, particularly in comparison to the bland bureaucratic language that pervades government documents today.  The note to the in-process study reads:

The 1926 act in regard to depletion on oil and gas wells includes a radical change from the 1924 act, consisting of the substitution of an arbitary 27 1/2 per cent of gross income for a depletion deduction in lieu of the depletion, on discovery value previously allowed.  It is most important to study the effect of this change as it was made on insufficient data.

Rates are lower, and the largest of oil firms can no longer claim the subsidy.  But the 1926 study, and however many more followed it, have never been sufficient to kill this tax break entirely.  It remains a significant subsidy to oil and gas today.

The cover page of the JCT report is below.  It can be read in full here.

If a company or an industry is going to get subsidized, there are good ways and there are better ways for it to happen if one is sitting in the corporate suite.  Among the best is to receive big subsidies that, while not flowing to your competitors, arrive in a form that nobody seems to notice.  The benefits of this structure are clear:  while the recipient gets a large slug of financial support, because few people see or understand the largesse, the political cost to both obtain and retain the subsidy is relatively low.  Master Limited Partnerships, the subject of Earth Track's most recent report Too Big to Ignore: Subsidies to Fossil Fuel Master Limited Partnerships, prepared for Oil Change International, fit the bill here perfectly:

• They are big.  Not only can beneficiary companies with hundreds of billions of dollars in market cap entirely escape corporate income taxes on profits earned from eligible activities, but they can also defer for many years any tax payments on the gobs of cash they distribute out to their owners.   
• They are mostly hidden.  Energy subsidy studies documenting tax breaks conducted in recent years by the US Department of Energy, the Congressional Budget Office, the US Treasury, and the Government Accountability Office have either not mentioned MLP subsidies at all, or done so only in passing with no related numerical estimate.  The Congressional Research Service did mention the tax break, but did not link it to energy.  Only the Joint Committee on Taxation (JCT) both linked the tax break to energy and included an estimated revenue loss figure.  Unfortunately, JCT's first estimates came only in 2008, though fossil fuel MLPs were already surging in earlier years.        
• They are selective.  Because most industries can't partake in this little game, the tax exemption for MLPs generates an especially big market boost to oil and gas over other energy options.  Nearly every other industry lost their ability to form tax-favored publicly-traded partnerships like MLPs in 1987, more than a quarter-century ago.  The reason?  Congress was afraid corporate income tax revenues would be gutted.  Since that time, fossil fuels have increasingly dominated this tax break, comprising well more than 75% of the sector by 2012. 
• They have (until this point) little political risk.  Fossil fuel MLPs continue to grow very quickly, and, unlike common and highly visible subsidies to wind and solar, MLP tax breaks never expire.

Selective Subsidies That Work Counter to National Fiscal and Environmental Goals

• MLP tax expenditures are part of a broader set of government subsidies that continue to underwrite activities contributing to climate change. These policies not only have large fiscal costs, but also work counter to the country's environmental goals and our national interest.

• Fossil fuel MLPs are growing quickly. The market capitalization of fossil fuel MLPs reached an estimated $385 billion by the end of March 2013, up from less than $14 billion in 2000. Related tax subsidies have been as high as $4 billion annually in recent years at the federal level alone.  Because the tax benefits from MLPs also ripple through state income tax codes, the combined state and federal MLP subsidies would be even higher.  

• Fossil fuel activities continue to dominate MLPs, both in number of firms and share of total market capitalization. As of the end of last year, 77 percent of MLPs were in the oil, gas, and coal sectors based on data collected by the National Association of Publicly Traded Partnerships (NAPTP), the main industry trade association. Firms in the fossil fuel sectors comprised 79 percent of total MLP market capitalization, though this figure is likely a bit low. Firms classified in other sectors also include some oil and gas-related businesses, including fracking sand and fossil fuel investments held by publicly-traded private equity firms such as Blackstone.

MLP Subsidies to Fossil Fuels:  Underestimated and Ignored for Too Long

• Government estimates of tax expenditures from energy-related MLPs are too low. Tax expenditures related to MLPs have been understated in recent years, and appear to be growing rapidly. Using a variety of estimation approaches, we estimate that tax preferences for fossil fuel MLPs cost the Treasury as much as $13 billion over the 2009-12 period, more than six times the official estimates.  

• MLP tax breaks are among the largest subsidies to fossil fuels. Although most government reviews of energy subsidies have not even included MLP-related tax expenditures, our estimates suggest this subsidy is among the top five largest fiscal subsidies to the fossil fuel sector and the largest single tax break to the sector.

• Growing share of production cycle for oil, gas, and coal can be organized as a tax-favored MLP - indicative that revenue losses will continue to grow. Financial innovation and IRS private letter rulings have expanded the fossil fuel market segments able to legally and successfully operate as tax-favored MLPs. Recent innovations have even established a precedent by which MLPs have successfully acquired taxable corporations, taking them off the corporate tax role in the process.

MLPs for All?  Providing Matching Tax Breaks to Renewables May Not be a Panacea

Though supported by many environmental groups, recent legislation introduced to expand MLP-eligibility to a range of new energy technologies may not be the panacea it is widely believed to be by supporters.  Further, the legislation is currently worded to include a range of energy technologies such as waste-to-energy, landfill gas, coal-to-liquids, and biomass that have a decidedly mixed environmental profile.

• Even in well-established market segments, there is a large overhang of fossil fuel assets poised to exit the corporate income tax system through conversion to MLPs. Less than 20 percent of total assets in the refiners, exploration and production, oil services, and coal sectors are presently held in a tax-favored MLP format (see Table). Even in the MLP-intensive midstream segment of the oil and gas market, conventional (taxable) corporate forms continue to own more than half of the assets. In all of these sectors, there is a huge pool of assets that multiple investment firms anticipate will convert to MLPs in coming years.

• Proposed expansion of MLP eligibility to renewables risks disproportionate benefits flowing instead to the fossil fuel sector. Current efforts to expand MLP treatment to renewables (The Master Limited Partnerships Parity Act) may entrench existing subsidy recipients.  The expansion will reduce the likelihood that MLP's tax-exempt treatment will be ended for fossil fuel producers, allowing the rapid growth of tax-exempt fossil fuel MLPs to continue unchecked. This legislation also would open MLP-eligibility to power generation for the first time, creating risks that this treatment will be extended from the current proposed set of recipients (biomass, solar, wind, geothermal) to all forms of power generation in coming years. This would disadvantage energy conservation, offset hoped for gains from the expansion in renewable sectors, and trigger very large tax losses to Treasury.

MLP Subsidy Termination a More Logical Path than Further Expansion

The MLP loophole should be closed; MLPs should be taxed as conventional corporations, not extended to new uses. This strategy, continuing what the United States started in 1986, would eliminate large and growing subsidies to fossil fuels.  Canada also successfully ended tax-favored treatment of an equivalent corporate structure in 2006.  In both cases, the affected industries did not wither and die; they adapted and moved on.  This newest crop of tax-favored fossil fuel firms will do the same.

1)  Poker, North Dakota style.  Using a logic that only an industry trade association could understand, the US state of North Dakota has announced plans to close $50m/year in loopholes to oil and gas.  Great!  End subsidies that make no sense, such as lower taxes on low production "stripper" wells that have been exploited by nearby activities producing at much higher rates.  But no reform is free, so the state officials are offering reduced tax rates on oil and gas in return.  The rub:  the reductions will cost the state an estimated $595m/year in new lost tax revenues, a mere 12x what they expect to get back from subsidy removal.  In what world is giving away $12 in state revenues for each $1 you claw back considered good business?  And it is not clear that even the 12:1 figure includes losses from new drilling incentives the state plans to put in place.  Due to fracking, North Dakota is the country's second largest oil producer, after only Texas. This change is a big deal.  For more information on how US states subsidize fossil fuels, go here.  (Thanks to Ben Schreiber for the ND article link). 

Upate, May 2, 2013:  The North Dakota House overwhelmingly rejected this proposed change:

North Dakota's House rejected a measure Wednesday aimed at closing an exemption enjoyed by oil companies in exchange for lower tax rates.

The Republican-sponsored bill - one of the most contentious of the legislative session - also would have given the Three Affiliated Tribes a greater share of the taxes collected from reservation oil production.

Representatives crossed party lines and overwhelmingly defeated the measure 71-21.

Democrats, who are the minority in both chambers, have been especially critical of the measure, saying the proposed tax framework would have cost the state hundreds of millions of dollars in lost revenue over the next few years by lowering taxes on oil companies.

2)  NEI thinks US nuclear export rules are too tight; looks to Russia as a model.  The Nuclear Energy Institute's review of problems with our country's restrictive nuclear export regime is nothing if not bold.  Here's their summary:

Compared to the nuclear export control regimes of Russia, Japan, ROK and France, the U.S. regime is, in many respects, more complex, restrictive and time-consuming to navigate and fulfill. Fundamental aspects of the U.S. export control regime were established over six decades ago – more than three decades prior to the creation of the Nuclear Suppliers Group (NSG).

During this time, the U.S. regime has evolved into a patchwork of requirements with layers of modifications. By comparison, the Russian, Japanese and ROK regimes are relatively modern and, in the case of the Japanese and ROK regimes, were recently amended to address post-9/11 nonproliferation concerns.

Now, I'm all in favor of looking to streamline the way government and business interact, but using Russia as a nuclear export model seems a sketchy strategy even for NEI.  After all, Russian nuclear exports have been a bit of an issue for other parts of the US government for quite some time.  But maybe that's the brilliance of the approach!  Adopt Russian nuclear export rules, boost business for US nuclear suppliers (and NEI's members) by allowing quicker, broader nuclear exports; and force a ramping up of government efforts and funding through the State Department and the IAEA to deal with the political implications of expanding nuclear capabilities abroad.  A job creation twofer!

3)  Subsidy Cycles, UK style.   Worried that your oil and gas operator didn't properly manage their environmental issues and taxpayers will be left paying reclamation costs?  No need to be.  Watch and learn from the UK - using subsidies to turn prior negligence into present opportunities!  A Brownfields Tax Credit "rejuvenates" an "elderly" offshore field, allowing Enquest PLC to buy the Thistle field in the North Sea and for production to go on.  No mention of what the government did wrong (poor oversight? inadequate bonding?) that resulted in the field being mismanaged by its prior operator in the first place; or of whether the government is trying to recapture reclamation costs (including the lost revenues due to the Brownfield subsidy) from that operator or its insurers.  (Thanks to Ron Steenblik for the article link). 

4)  State subsidies for job creation:  states are losing the bidding war.  The Job Creation Shell Game, released in January, is a great review by Good Jobs First (a Washington, DC-based NGO) examining job poaching from one state to another.  Not only do states routinely pay tax rebates to move old jobs from one state to another, but they then enter a process where large employers routinely threaten to move, extorting "retention" payments for staying put.  Net job gains are small; net tax losses are big.  And who do  you think is left having to make up the lost tax revenues?  Us, of course.

5)  Relative scale:  fossil fuel subsidies versus spending on international development.  An interesting comparison of the scale of fossil fuel subsidies versus fast start climate spending by Oil Change International illustrates that nearly everywhere they looked, the subsidies to increased use of fossil fuels greatly exceeded the spending to start addressing the effects of consuming so many fossil fuels.  Yes, some subsidies help the poor, and not all climate spending is efficient.  But the gross comparison underscores how important it is for any effort to address climate change to incorporate ending subsidies as a central strategy.

In the movie Field of Dreams, actor Kevin Costner hears a voice in his head telling him "If you build it, he will come."  The "it" is a baseball diamond in the middle of his corn field; the "he" is his dead father.  Onlookers, of course, think he is crazy, which perhaps he is.  But at least in the movie the costs to build and maintain the diamond were not paid by the government.  If the idea was a bust, it was Costner's character, not taxpayers, footing the bill.  And the environmental impacts?  Immaterial.

Oil and gas extraction from the Arctic seems to be following the same "build it and they will come" playbook.  The scale of this game, however, is very big.  It is so big that I'm reminded of the push for massive, heavily subsidized, irrigation projects throughout the US west -- engrossingly documented by Marc Reisner in Cadillac Desert.   High risk capital infrastructure is being paid for by the state.  Returns are irrelevant so long as the infrastructure paves the way for investment in the region's energy resources.  Assume capital costs will eventually be written off and the services from the capital look cheap.  Environmental risks?  Perhaps the dam model applies here as well:  promise you'll be careful when you can't ignore the issue, but ignore it whenever you can.

Arctic activities getting attention; associated subsidies not so much

Documentation of the rush for Arctic oil has been growing for some time.  A useful backgrounder on the Russian perspective by Dmitri Trenin and Pavel K. Baev, The Arctic: A View from Moscow, for example, was released by the Carnegie Endowment for International Peace in 2010. But what is still not getting the attention it deserves is the role of subsidies.  It is these government handouts in all their guises that are ultimately making firms invest in a high-cost, high-risk marginal energy resource called the Arctic circle.  Arctic oil and gas, after all, competes with easier supplies around the world.  

These subsidies are driving the construction of infrastructure that will jump-start and greatly expand Arctic oil and gas development well beyond the levels we would see if market forces alone were driving investment.  The pressure to subsidize big is not entirely surprising.  There is substantial overlap between energy, geopolitical designs on the region, and an effort to expand access (and perhaps domination) of newly thawing waterways.  These are powerful drivers for government intervention regardless of economic cost, particularly in Russia. 

But the environmental price is likely to be high.  Those of us who worry about all sorts of damage to the pristine Arctic environmental really ought to be banding together to document the subsidies and demonstrate the economic irrationality of the development.  If this has started to happen, I've not seen it.

The article below, from the Voice of Russia last month, was forwarded to me by Steve Kretzmann of Oil Change International.  It is a useful example of what is going on, though based on past experience my guess is that the article captures but a portion of the many ways the government is providing subsidies to, and shifting risk from, private investors.  The article is reposted below with subsidy-related commentary.  Bold highlights have been added to flag subsidy coverage within the article; the indented text preceded by asterisks is my own.

Yamal LNG: what isn't being subsidized?

Arctic exploration in practice: Yamal LNG

"Practical development of Arctic mineral deposits, which is about to commence in Russia, is not needed by Russia alone. Oil and gas from that region will be supplied to different markets and will help solve energy deficit in various countries. Take, for instance, the Yamal LNG project - gas from the Russian Arctic can be shipped by tankers to practically any market. Thus, gas from the Russian Arctic will be used in Asia, in Europe or, if necessary, in North America. The Yamal LNG project provides for building a gas liquefaction plant near the Sabetta port in the eastern part of the Yamal Peninsula.