Britain’s Windfall Tax Is a Light Breeze

The UK government announced the fiscal policy suite known as its semi-annual Spring Budget yesterday, and as usual, it was a mix of smaller-than-advertised tax cuts and some niche tax hikes to offset them—otherwise known as the standard pre-election grab bag one should expect from either major party there. Among the revenue-generating measures? The extension of the windfall profits tax on oil and gas companies, which adds a 35% surcharge to net income from UK oil and gas extraction. It will now sunset in March 2029 instead of 2028 unless oil and gas prices fall enough to cancel it in the meantime, making this a nifty time to check in on the tax’s market impact.

To that end, we made you Exhibit 1, which compares UK Energy stocks’ returns with global stocks’ since the government announced the tax in May 2022. As you will see, they initially underperformed on the news, but it was short-lived. After a similarly short burst of outperformance in late 2022 and early 2023, UK and global Energy sector returns have been more or less in line over the past year. The tax, it would seem, is a non-factor.

Exhibit 1: MSCI UK Energy IMI / MSCI World Energy

Source: FactSet, as of 3/7/2024. MSCI UK Energy IMI and MSCI World Energy returns with net dividends, 4/30/2022 – 3/6/2024. Indexed to 1 at 4/30/2022.

As it should be, in our view. The MSCI UK Energy IMI consists predominantly of two major global companies, which comprise 97.6% of its market capitalization.^[i] The remaining 2.4% is a handful of small domestically focused companies.^[ii] The tax hits domestic energy revenue only. That means UK companies, while domiciled in Britain, aren’t hugely exposed to it. Per FactSet, only about 14% of the index’s revenues come from the UK.^[iii] So the tax, while a headwind, affects only a small share of profits—a good reminder that taxes are just one variable, of many, affecting earnings. It may indeed be a headwind to new UK oil and gas investments and drilling, as firms have warned, but that is a global oil supply impact, not a UK-specific stock return impact—a key difference. And we suspect that if these oil majors saw crude prices rise enough, they would just up production elsewhere globally.

Earlier this week, we counseled readers that taxes have no preset market impact—hikes aren’t auto-bearish (or bullish), and cuts aren’t inherently bullish (or bearish). This is a prime example, in our view. Is it a burden? Yes. Does it have downstream consequences? Probably, if the government’s investment allowances aren’t sufficient to change the incentives. Is it economically wise? We suspect it isn’t. But is that enough to make UK Energy stocks the world’s great disappointment? Evidently not—markets seemingly priced it and moved on, as they usually do with tax changes.