The Budget takes place on 17th March 2015 and as always there is much speculation as to what it will and won’t include. One industry that is eagerly awaiting Osborne’s Budget is the North Sea oil and gas industry. Tax cuts and rises may well play a key role in the Budget, but this is one sector where a possibly large tax cut is expected.
The tax paid by this industry is very high compared to others, potentially reaching 80%. The tax rate was increased some years ago and it is now thought that it may come back down. One key factor is oil prices: with such huge decreases in the price of oil relative to when the tax on the industry was increased, the industry is now asking for these tax rises to be reversed. The industry has suggested that a 10% tax cut is a possibility and this would make a big difference for the industry.
Danny Alexander, the chief secretary to the Treasury, said:
“We’ve been very clear that the direction of travel for tax in the North Sea needs to be downwards … And that needs to be even stronger given the low oil price we see at the moment. We want people to have the confidence to invest for the long term future of the North Sea … And so George Osborne and I have been listening very carefully to what the industry has been saying …People will have to wait and see what we say on Wednesday [Budget day], but I hope very much that it will give the North Sea that confidence that we all want to see for one of Britain’s most important industries.”
We may also see further changes for this industry, such as allowances to encourage further investment, as costs of investment are extremely high and this has led to many years of under-investment. These changes are hoped to regenerate this industry. Any change in tax allowances or tax rates will have an impact on tax revenue and it is not necessarily the case that an increase in tax will lead to a rise in revenue or a fall in revenue. The relationship between tax rates and tax revenues can be very complex. The following articles consider this particular issue and what the Budget will do for this industry.
North sea oil groups set for tax breaks in budget Financial Times, Christopher Adams and George Parker (16/3/15)
What does the Budget 2015 mean for the North sea oil industry? The Telegraph, Andrew Critchlow (16/3/15)
Britain needs oil tax cuts to attract North Sea Investment Reuters, Karolin Schaps and Claire Milhench (16/3/15)
Treasury paves way for major tax cut for North sea BBC News, Kamal Ahmed (16/3/15)
Home of Brent Oil benchmark seeks help as investment slumps Bloomberg, Firat Kayakiran (17/3/15)
Questions
- If a tax is imposed on an industry, what type of effect might this have on costs of production? Use a diagram to support your answer.
- In the BBC News article, North Sea Oil is referred to as a cash cow. What does this mean?
- If taxes are cut for the North Sea Oil industry, how will this affect its costs and what might it doe for investment?
- What will happen to tax revenues if taxes are cut? Use the Laffer curve to help your answer.
- How has the North Sea Oil industry been affected by falling oil prices? Does this offer a justification for a tax cut?
The rate of inflation in the UK is measured using the Consumer Prices Index (CPI). This is made up of a basket of goods and the ONS updates this ‘basket’ each year to ensure it is representative of what the average UK household buys. The basket contains 703 items, with 110,000 individual prices collected each month.
In past years, items such as lip gloss have been added to the basket of goods, together with tablet computers and teenage fiction. In the recent update by the ONS, e-cigarettes have been added, together with specialist ‘craft’ beers and music streaming. On the other hand, other items have been removed, as the world changes. For example, during the recession, champagne was removed as an item that the representative household was no longer buying. In other cases, items are removed as they become outdated or obsolete with technology changing. This is the case with satellite navigation systems. As people turn to using their smartphones to navigate their way from A to B, satellite navigation systems are no longer seen as an item bought by the representative household.
The UK inflation rate is at an all-time low of 0.3% and there have been concerns that it may become negative, meaning we enter the world of deflation. However, if this does occur, many suggest that it is not bad deflation, as it is being driven by the extremely low oil prices. No matter what the inflation rate, the ONS will always continue to update the basket of goods that calculates inflation. It is therefore essential that these changes are made each year, as consumer buying habits do fluctuate considerably, as income changes, technology changes and general tastes change. The following articles consider what’s in and what’s out.
From craft beer to e-cigarettes, inflation basket reflects Britain’s changing shopping habits The Guardian, Katie Allen (17/3/15)
Inflation-measuring basket of goods adds protein powder, e-cigarettes The Grocer, Andrew Don (17/3/15)
E-cigareets and craft beers in updated inflation basket BBC News (17/3/15)
E-cigs added to inflation basket Mail Online (17/3/15)
Craft beer, e-cigarettes and protein shakes dded to price basket used to calculate inflation Independent, Hazel Sheffield (17/3/15)
U.K. hipsters and gym junkies win approval in new price basket Bloomberg, Tom Beardsworth (17/3/15)
Spotify in and sat navs out: take a look at the new inflation basket The Telegraph, Szu Ping Chan (17/3/15)
E-cigarettes, craft beer and Spotify enter UK inflation basket Reuters, Toby Melville (17/3/15)
Craft beer and e-cigarettes added to CPI basket Financial Times (17/3/15)
Questions
- What is the difference between the CPI and RPI? Which is usually higher? Explain your answer.
- Explain why champagne was removed from the basket of goods during the recession. What is sensible?
- How is the CPI calculated and hence how is inflation measured?
- Why has there been a movement towards chilled pizzas and away from frozen pizzas? Is the change likely to affect their relative price? Use a diagram to support your answer.
- What impact has technological progress had on the basket of goods that the representative household purchases? Do you think that technological progress make it more or less important for the basket of goods to be reviewed annually?
- Do you think products such as the iPad and e-cigarettes should be included in the CPI? Are they truly representative?
- In the BBC News article, you can access a list of the products that are ‘in and out’. Is there anything on there that you think should be in or that should be out? Be sure to justify your answer!
In March 2009, interest rates in the UK fell to a record low of 0.5%. At the time, it is unlikely that anyone expected that we would still be talking about such low interest rates 6 years later. There has been no movement in the UK rate of interest over the past 6 years and many believe that we are unlikely to see an increase before 2016 or late 2015 at the earliest. With inflation at 0.3%, there is ‘little reason to raise the cost of borrowing’.
The cut in interest rates back in 2009 was in response to the financial crisis and recession. A key instrument of monetary policy, interest rates affect many of the components of aggregate demand. Lower interest rates reduce the cost of borrowing, reduce the return on savings and hence encourage consumption. They can also reduce mortgage repayments and have a role in reducing the exchange rate. All of these factors are crucial for any economic stimulus. As the recovery in the UK took hold, discussions started to focus on when (and not if) interest rates would increase. As the 6 year anniversary occurs, with the MPC keeping rates at 0.5% for March, this question has once again been raised.
Interest rates are used to target inflation and the target in the UK is 2% +/- 1%. With inflation at 0.3% and some predicting that it will turn negative, thanks to such a large fall in oil prices, perhaps the most likely change in interest rates is that they will fall further. A senior Economic Adviser to the EY Item Club commented:
“While the risks of an earlier rate rise have probably increased lately, we still think it most likely that the Bank will wait until February 2016, by which time inflation will be back above 1% and heading towards the 2% target.”
This was echoed by the Chief Economist at the British Chambers of Commerce, who said:
“The strengthening pound against the euro is already posing challenges for many UK exporters and higher interest rates would only make matters worse…Given this background, business confidence will be strengthened if the Monetary Policy Committee (MPC) clearly states that interest rates are likely to stay on hold until at least early 2016.”
Some might question the logic of keeping interest rates so low, given that unemployment is falling and the economy is growing. In such cases, we would normally expect interest rates to increase, especially given how low they are and the fact that it has been 6 years since they went down. However, with oil prices down, inflation has fallen and wage growth does remain relatively weak. Furthermore, there are still some areas within the UK that are still in the recovery process.
The strength of the economy relative to Europe is also putting upward pressure on the pound, which will adversely affect the competitiveness of UK exports. These factors together mean that retaining interest rates at 0.5% received unanimous support amongst the MPC. The only disagreement was on the future direction of interest rates. It is this disagreement that is perhaps what is causing problems, as confirmation of what will happen to interest rates over the rest of 2015 would give greater certainty to an economy. The following articles consider this anniversary.
UK interest rates mark six-year anniversary at record low The Guardian, Angela Monaghan (5/3/15)
UK interest rates mark six years at record low of 0.5% BBC News (5/3/15)
Bank of England keeps interest rates on hold Financial Times, Emily Cadman (5/3/15)
Carney facing seven-year itch as BOE holds rates Bloomberg, Jennifer Ryan (5/3/15)
Bank of England rates have now been on hold six years. Here’s how it has affected you The Telegraph, Szu Ping Chan (5/3/15)
Bank of England keeps rates on hold, six years after crisis cut Reuters (5/3/15)
Bank of England keeps key rate at record low Wall Street Journal, Jason Douglas (5/3/15)
Questions
- By outlining the key components of aggregate demand, explain the mechanisms by which interest rates will affect each component.
- How can inflation rates be affected by interest rates?
- Why is there a debate amongst the MPC as to the future direction of interest rates?
- The Chief Economist at the British Chambers of Commerce has said that the strengthening pound is creating problems in the UK and higher interest rates would make matters worse. Why is this?
- Who would be helped and harmed by a rate rise?
- Consider the main macroeconomic objectives and in each case explain whether economic theory would suggest that interest rates should (a) fall , (b) remain at 0.5% or (c) rise.
‘The world is sinking under a sea of debt, private as well as public, and it is increasingly hard to see how this might end, except in some form of mass default.’ So claims the article below by Jeremy Warner. But just how much has debt grown, both public and private? And is it of concern?
The doomsday scenario is that we are heading for another financial crisis as over leveraged banks and governments could not cope with a collapse in confidence. Bank and bond interest rates would soar and debts would be hard to finance. The world could head back into recession as credit became harder and more expensive to obtain. Perhaps, in such a scenario, there would be mass default, by banks and governments alike. This could result in a plunge back into recession.
The more optimistic scenario is that private-sector debt is under control and in many countries is falling (see, for example, chart 1 in the blog Looking once again through Minsky eyes at UK credit numbers for the case of the UK). Even though private-sector debt could rise again as the world economy grows, it would be affordable provided that interest rates remain low and banks continue to build the requisite capital buffers under the Basel III banking regulations.
As far as public-sector debt is concerned, as a percentage of GDP its growth has begun to decline in advanced countries as a whole and, although gently rising in developing and emerging economies as a whole, is relatively low compared with advanced countries (see chart). Of course, there are some countries that still face much larger debts, but in most cases they are manageable and governments have plans to curb them, or at least their growth.
But there have been several warnings from various economists and institutes, as we saw in the blog post, Has the problem of excess global debt been tackled? Not according to latest figures. The question is whether countries can grow their way out of the problem, with a rapidly rising denominator in the debt/GDP ratios.
Only mass default will end the world’s addiction to debt The Telegraph, Jeremy Warner (3/3/15)
Questions
- What would be the impact of several countries defaulting on debt?
- What factors determine the likelihood of sovereign defaults?
- What factors determine the likelihood of bank defaults?
- What is meant by ‘leverage’ in the context of (a) banks; (b) nations?
- What are the Basel III regulations? What impact will they have/are they having on bank leverage?
- Expand on the arguments supporting the doomsday scenario above.
- Expand on the arguments supporting the optimistic scenario above.
- What is the relationship between economic growth and debt?
- Explain how the explosion in global credit might merely be ‘the mirror image of rising output, asset prices and wealth’.
- Is domestic inflation a good answer for a country to the problems of rising debt denominated (a) in the domestic currency; (b) in foreign currencies?
Many UK coal mines closed in the 1970s and 80s. Coal extraction was too expensive in the UK to compete with cheap imported coal and many consumers were switching away from coal to cleaner fuels. Today many shale oil producers in the USA are finding that extraction has become unprofitable with oil prices having fallen by some 50% since mid-2014 (see A crude indicator of the economy (Part 2) and The price of oil in 2015 and beyond). So is it a bad idea to invest in fossil fuel production? Could such assets become unusable – what is known as ‘stranded assets‘?
In a speech on 3 March 2015, Confronting the challenges of tomorrow’s world, delivered at an insurance conference, Paul Fisher, Deputy Governor of the Bank of England, warned that a switch to both renewable sources of energy and actions to save energy could hit investors in fossil fuel companies.
‘One live risk right now is of insurers investing in assets that could be left ‘stranded’ by policy changes which limit the use of fossil fuels. As the world increasingly limits carbon emissions, and moves to alternative energy sources, investments in fossil fuels and related technologies – a growing financial market in recent decades – may take a huge hit. There are already a few specific examples of this having happened.
… As the world increasingly limits carbon emissions, and moves to alternative energy sources, investments in fossil fuels and related technologies – a growing financial market in recent decades – may take a huge hit. There are already a few specific examples of this having happened.’
Much of the known reserves of fossil fuels could not be used if climate change targets are to be met. And investment in the search for new reserves would be of little value unless they were very cheap to extract. But will climate change targets be met? 
That is hard to predict and depends on international political agreements and implementation, combined with technological developments in fields such as clean-burn technologies, carbon capture and renewable energy. The scale of these developments is uncertain. As Paul Fisher said in his speech:
‘Tomorrow’s world inevitably brings change. Some changes can be forecast, or guessed by extrapolating from what we know today. But there are, inevitably, the unknown unknowns which will help shape the future. … As an ex-forecaster I can tell you confidently that the only thing we can be certain of is that there will be changes that no one will predict.’
The following articles look at the speech and at the financial risks of fossil fuel investment. The Guardian article also provides links to some useful resources.
Articles
Bank of England warns of huge financial risk from fossil fuel investments The Guardian, Damian Carrington (3/3/15)
PRA warns insurers on fossil fuel assets Insurance Asset Risk (3/3/15)
Energy trends changing investment dynamics UPI, Daniel J. Graeber (3/3/15)
Speech
Confronting the challenges of tomorrow’s world Bank of England, Paul Fisher (3/3/15)
Questions
- What factors are taken into account by investors in fossil fuel assets?
- Why might a power station become a ‘stranded asset’?
- How is game theory relevant in understanding the process of climate change negotiations and the outcomes of such negotiations?
- What social functions are filled by insurance?
- Why does climate change impact on insurers on both sides of their balance sheets?
- What is the Prudential Regulation Authority (PRA)? What is its purpose?
- Explain what is meant by ‘unknown unknowns’. How do they differ from ‘known unknowns’?
- How do the arguments in the article and the speech relate to the controversy about investing in fracking in the UK?
- Explain and comment on the statement by World Bank President, Jim Yong Kim, that sooner rather than later, financial regulators must address the systemic risk associated with carbon-intensive activities in their economies.
The Budget takes place on 17th March 2015 and as always there is much speculation as to what it will and won’t include. One industry that is eagerly awaiting Osborne’s Budget is the North Sea oil and gas industry. Tax cuts and rises may well play a key role in the Budget, but this is one sector where a possibly large tax cut is expected.
