UK: On The Horizon 2014: UK Energy Law And Regulation – Oil And Gas Briefing

Last Updated: 1 March 2014
Article by Danielle Beggs, Humphrey Douglas, John Stockdale and Roy Pinnock

UK shale: a look back at 2013

Political and economic context

This interactive note is based on presentations given to a seminar on UK Energy Law and Regulation at Dentons' London office on 22 January 2014. On the same day, the European Commission published two reports highlighting how the "shale revolution" has allowed US industry to benefit from lower gas prices than those faced by its competitors in the EU (see the Commission's Energy Economic Developments in Europe report and analysis of prices). Two days later, David Cameron told the World Economic Forum in Davos that shale could help to make EU industry more competitive, enabling it to "re-shore" jobs in the same way as fracking had done in the US.

Work commissioned by DECC from consultants Navigant and published in July 2013 indicates that it will be quite a while before UK shale has an appreciable impact on UK energy prices, and that that impact is likely to be modest. Some commentators have pointed out that DECC's own estimates of future gas price scenarios are even less optimistic.

But for the UK's Coalition Government, the prospect of a UK shale industry also represents in its own right the prospect of economic growth. Estimates of the number of jobs that could be created by UK shale developments vary considerably, but more than one is in the tens of thousands. The prospect of additional tax receipts from onshore unconventional gas projects boosting the public finances is also attractive to the UK Treasury as revenue from offshore oil and gas developments dwindles.

The Conservatives in the Coalition may also hope that their enthusiasm for shale will play well with those who criticise the Government's continued favourable treatment for renewables. But voters who are not keen on wind or solar farms may turn out to be no more enthusiastic about fracking if it happens in their back yards. So, while Government has been at pains to portray the UK regulatory regime as user-friendly for operators, it also wants to stress that best environmental practice will be the norm and that the alleged excesses of "Wild West" US fracking will be avoided in the Home Counties. (See the Government's overview page on shale.)

Government facilitation of shale development

Over the course of 2013, Government announcements focused on three areas: tax relief, demystifying the regulatory processes that shale operators have to navigate, and making sure that communities receive some financial reward for hosting shale developments.

Proposals on tax relief were trailed in Budget 2013 and formally consulted on in July 2013. UK oil and gas production is taxed by way of (i) 30% corporation tax that is subject to a "ring fence"; (ii) a 32% "supplementary charge" on ring-fenced profits (excluding finance costs); and (iii) in the case of older fields, petroleum revenue tax. The ring fence aims to ensure that profits on UK and UK Continental Shelf (UKCS) oil and gas extraction are not wiped out by a company's losses on other activities. The key elements of the Government's proposals were (i) to exempt a portion of production income from the supplementary charge – reducing the effective tax rate on that portion from 62% to 30% at current tax rates; and (ii) to extend the Ring Fence Expenditure Supplement (RFES) for shale projects from six to ten accounting periods.

The Treasury proposed that the amount of production income exempt from the supplementary charge would be a proportion of the capital expenditure incurred in relation to the shale gas pad. The relevant capital expenditure would be limited to expenditure that would attract 100% first year capital allowances. Companies would start to generate and hold the allowance as soon as they incurred capital expenditure on a pad. Costs incurred prior to the effective date of the introduction of the pad allowance would not contribute to the generation of the allowance. The amount of allowance activated (i.e. made available to offset against profits) in any accounting period would be no more than the amount of production income from the pad. Any activated allowance not used to reduce the supplementary charge otherwise payable by a company in a particular accounting period would be carried forward to the next. (See HM Treasury's Consultation on tax relief.)

In its publications on the regulatory processes applicable to shale projects, Government has been seeking to reassure and provide guidance to the public, developers and local mineral planning authorities. This process began in July 2013 with the Department for Communities and Local Government's Planning Practice Guidance for Onshore Oil and Gas (see also Dentons' e-alert on Government's July 2013 package of announcements to encourage shale development). It continued in December 2013 when DECC published "regulatory roadmaps" for onshore oil and gas exploration in England, Wales, Scotland and Northern Ireland. Also in December 2013, DECC sought views on a Strategic Environmental Assessment for further onshore oil and gas licensing, which will inform the next onshore licensing round.

As regards financial rewards for host communities, Government welcomed the Community Engagement Charter launched by the UK Onshore Operator Group (UKOOG) in June 2013. UKOOG proposed that host areas should receive £100,000 per well site at the exploration/appraisal stage and 1% of revenues at production stage, allocated approximately 2/3 to the local community and 1/3 at the county level. (For some suggestions as to how to organise community benefit schemes, see  Dentons' e-bulletin on use of community interest companies (CICs) for community benefits programmes of September 2013.)

Commercial activity

In terms of shale activity "on the ground", media attention focused on the activities of Cuadrilla. In June, Centrica took a 25% stake in Cuadrilla. Later in the year, the drilling of a well by the company at Balcombe in Sussex became a major focus of anti-shale protest for a few weeks – somewhat ironically, since the well at the centre of the protests was not going to be fracked (and it now appears that there will be no need to use fracking to exploit the potential of the Balcombe rock formations). Amongst other things, these protests, coming in the slow news month of August, helped to spark a wider national debate about shale, as well as highlighting the potentially substantial policing costs that local authorities (and perhaps ultimately operators) may expect to face where stakeholder management does not succeed in smoothing the path of development.

While the search for UK shale gas continued, there were also reminders of the impact that the US shale revolution has in the UK. By depressing domestic demand for coal in the US, shale has helped to keep some of our remaining coal-fired power stations supplied with cheap coal and to boost their share of UK electricity supply. And towards the end of the year, Ineos announced that its Grangemouth plant, which had apparently come close to being permanently shut down a few weeks earlier, would start to import ethane derived from US shale gas in 2016.

UK shale 2014 – the year to date

Government and industry initiatives

Official activity on shale paused briefly over the Christmas and New Year holiday period, but has already resumed. On 13 January 2014, the Prime Minister announced that local authorities would be able to keep 100% of the business rates from shale developments. At the same time, UKOOG announced further details of its community engagement programme and a skills study.

For commentary on these and other recent developments, see Dentons' UK Planning Law Blog (a "year of shale for planners" and other shale-related posts).

Commercial progress

Also in January 2014, Total became the first oil and gas "major" to invest in UK shale. The company was advised by a team from Dentons' London office led by Danielle Beggs. Total has acquired a 40% interest in two licences in the Gainsborough Trough area of the East Midlands which cover an area of 240 km2. On completion of the transaction, Total's partners in the project will be GP Energy Limited (a subsidiary of Dart Energy Europe) (17.5%), Egdon Resources UK Ltd (14.5%), Island Gas Ltd (IGas) (14.5%) and eCorp Oil & Gas UK Ltd (13.5%). IGas will be the operator of the initial exploration programme, with Total taking over operatorship as the project moves towards development.

Onshore oil and gas in the UK, at least in its "unconventional" forms, has so far generally been the preserve of a group of small and specialised companies with limited resources to fund test drilling programmes for shale and the extensive preparatory work in terms of regulatory clearances and surveys that needs to be completed before drilling can begin. Total's move shows that there is now enough interest and confidence in the UK shale scene to justify the involvement of companies with sufficient resources to take the more promising prospects to the next stage.

Total and the other larger players that are likely to follow its example face a different regulatory environment from the one they are used to if they have been involved in UK offshore projects. They are moving from a world in which DECC regulates almost all aspects of their work under the licensing regime to one in which they have to manage carefully relationships with a range of stakeholders and deal with a number of different authorities, some of which will be very sensitive to local views.

UK shale 2014 – looking forward

Political and regulatory activity

On 22 January 2014, the European Commission adopted a communication and a recommendation on fracking. EU Environment Commissioner Janez Potočnik said: "Shale gas is raising hopes in some parts of Europe, but is also a source of public concern. The Commission is responding to calls for action with minimum principles that Member States are invited to follow in order to address environmental and health concerns and give operators and investors the predictability they need." (See the Commission's webpage on Environmental Aspects on Unconventional Fossil Fuels.)

The recommendation is not legally binding on Member States. Before the Commission's announcement, it was reported that a proposal for binding EU legislation regulating the shale industry had been defeated by the UK. The possibility of further action at EU level cannot be ruled out. See further our briefing on the Commission's recommendation. Some have commented that, if the UK shale industry has gained in terms of avoiding extra regulation, it may also have lost out in terms of winning a "social licence", since such additional regulation might have increased public confidence as regards environmental issues around shale. However, these risks may be mitigated by the Environmental Impact Assessment process that fracking sites will undergo before they receive development consent.

In terms of domestic legislation, the Finance Bill 2014 will include provisions legislating for the outcome of the July 2013 consultation on tax relief for shale gas. A draft of the relevant provisions, which will take effect as from 5 December 2013 once they enter into force, was published for comment at the time of the Autumn Statement (see HMRC note on shale tax relief).

The Government's thinking on a number specific points in relation to taxation of shale developments is set out in the summary of responses to the July 2013 consultation. The proportion of production income to be set aside from the supplementary charge will be 75%. The extension of RFES from six to 10 accounting periods will apply to all onshore projects, not just unconventional ones.

DECC will hold a 14th licensing round after the consultation on the Strategic Environmental Assessment relating to it has concluded in March 2014. There will be considerable interest in this round. The licences awarded as a result of it may include a new version of the Petroleum Exploration and Development Licence model clauses.

There will continue to be debate over the economic and environmental merits of shale.

On the ground

It is possible that standard documentation such as the industry template for Joint Operating Agreements may be modified to reflect the shale context.

There will be more transactions like Total's acquisition of a stake in an existing shale play. However, it is likely to be some time before any shale project enters the production phase, and a number of years before any appreciable amount of shale gas is produced in the UK.

There is no doubt that, as a destination for investment in shale, the UK currently enjoys an element of competitive advantage within the EU, since a number of other EU jurisdictions, such as France and Poland, have rejected shale or given investors reason to doubt their commitment to it. But the potential for successful shale projects exists in many parts of the world and even major oil companies' resources are finite. The UK authorities, at all levels, will need to continue to perform well on shale in order to ensure that the UK receives its fair share of investment in shale projects.

Offshore and other developments

The Wood Review

Background

The latest DECC projections for UKCS Oil and Gas Production (October 2013) paint a somewhat gloomy picture of the future of the UK offshore industry. Although investment is currently at a record high, production has declined by 38% over the last three years, entailing a loss of £6 billion in tax receipts. Exploration drilling is down by 50% over 10 years.

Against this background, the Secretary of State for Energy and Climate Change, Ed Davey, commissioned Sir Ian Wood to lead a review of the regulation of the UKCS with a view to determining what should be done to maximise the economic recovery of the UK's remaining offshore oil and gas resources (see Wood Review: Terms of Reference (June 2013)). The Wood Review's incisive and impressively short Interim Report (November 2013) has been generally well received. It contains a wide-ranging critique of the status quo, which suggests that Sir Ian's work could have far-reaching consequences when his final report is published in a few months' time.

The Review focuses on HM Treasury's role through the design of the tax system; the regulatory functions carried out by DECC (i.e. economic, rather than environmental or health and safety regulation); and the structure and behaviour of the industry itself. It finds that change is needed in all three areas in order to achieve the objective of maximising economic recovery from the UKCS as a whole (MER UK), rather than just from some individual fields.

Tax

Wood notes that the tax system needs to be more consistent and stable, whilst at the same time recognising the variety of assets that make up the UKCS oil and gas industry, which range from the very mature to new discoveries and from relatively straightforward prospects to assets which can only be developed, or continue to be developed, using new and innovative techniques.

Regulation

Wood finds that DECC, as Regulator of the UKCS, is doing absolutely as well as can be expected given that it does not have either the tools for the job as it now needs to be done or anything like sufficient resources to deal with the complexity of the modern North Sea. The Interim Report cites the fact that, 20 years ago, DECC's predecessor department had almost twice as many staff but less than a third of the number of fields to administer. Its current complement of 50 personnel is half the number who regulate the Netherlands offshore industry. As a result, "Industry is clearly saying they want a stronger regulator, able to become proactively involved, minimise disruption and delays, and facilitate and accelerate progress.".

Wood's answer is that a new, arm's length, regulatory body should be created, fully funded by the industry and with additional technical, legal and business know-how. It should "ensure" that Government and industry have a 30-year strategy to maximise economic recovery, and its representatives should be entitled to attend the Operating and Technical Committee Meetings of any licensee (as happens in Norway and the Netherlands).

Licences should require the licensee to act in a way consistent with the principle of MER UK. This will have implications in relation to such matters as maximising production efficiency, demonstrating effective utilisation of infrastructure, and collaborative development of regional clusters.
Playing more of a leadership role than DECC has, the new regulator should develop strategies in key areas such as use of improved and enhanced oil recovery, regional development plans (starting with the Southern North Sea) and access to finance for small and medium-sized operators.

Although the Review's vision of a new regulator seeks to address UKCS issues and sees those issues as the priority, it does not rule out the new regulator assuming similar responsibilities in relation to the onshore industry in due course.

Industry behaviour

Among the things the proposed new regulator would have to get to grips with is the "over-zealous legal and commercial behaviour between operators" that Sir Ian sees as an obstacle to the kind of collaboration which he sees as essential. This may involve it in finding ways to avoid competition law concerns in connection with such matters as sharing survey data, or in taking a role in resolving disputes between licensees or infrastructure access problems.

According to Wood, the operators "have brought many of their problems on themselves". They have constrained investment and focused on short-term returns. Some have shown a "predisposition not to collaborate" when collaboration is what is needed. West of Shetland is singled out as an example where field and infrastructure collaboration, essential for MER UK, has been lacking.

The industry is criticised for taking too long to negotiate agreements; not making use of simplified or standardised documents, processes and procedures; and not making the most of existing learning. It should develop a plan to improve this state of affairs, and, if it does not produce a satisfactory result within a year, the regulator should impose its own solution.

Next steps

The final report of the Wood Review is expected to be delivered to DECC by the end of January 2014. It seems clear that it will advocate radical change to fundamental features of the taxation, regulation, organisation and behaviour of the UK offshore industry. Ed Davey has already been quoted as saying that he thinks that, over the next five to 10 years, the impact of the Wood Review will be "much bigger than shale gas" for the UK. Whilst a number of the changes that are likely to be proposed would do no more than bring the UK into line with practice in other countries, they would represent a big departure from the traditionally "light touch" or laissez-faire approach to UKCS regulation.

Whether the Coalition Government will have the appetite or the Parliamentary time to start to tackle the implementation of these proposals in the course of 2014 remains to be seen, but, if the final report is as strongly worded as much of the interim report, it may be hard for it not to take some sort of steps in the direction indicated by Sir Ian before the General Election.

Referendum on Scottish independence

On 18 September 2014, Scottish voters will be asked whether they want their country to become independent. What impact could this have on the UKCS oil and gas industry?

The Scottish Government has plans for the whole energy sector. See, for example, its Generation Policy Statement (aiming to generate the equivalent of 100% of Scottish demand from renewables and largely decarbonise electricity generation by 2030) and its paper on Economic and Competition Regulation in an Independent Scotland (a single Scottish regulator for all utilities). But it is its work on Maximising the Return from Oil and Gas in an Independent Scotland that carries the greatest conviction, since the subject is by far Scotland's largest industry and the tax receipts from that industry would be among the mainstays of an independent Scotland's finances.

The Scottish Government's White Paper criticises successive Westminster Governments for too frequently making changes to the UKCS tax regime (e.g. 16 substantive changes in the last 10 years) and for not having created a sovereign wealth fund from oil and gas revenues in the manner of Norway and other countries. The Government of an independent Scotland, having assumed responsibility for the 98.8% of UK offshore oil which falls within Scotland's geographical share of the current UKCS (making it the largest oil producer and second-largest gas producer in the EU), would take a different approach. It would "plan Scotland's public finances and borrowing requirements on the basis of a cautious forecast of oil and gas revenues, transferring any surplus to [a] stabilisation fund and withdrawing resources should out-turn oil and gas receipts come in below forecast".

It appears that, if Scotland becomes independent, the principles of the Wood Review are just as likely to be implemented in relation to whatever part of the current UKCS is attached to the new country.

Before any of this can happen, Alex Salmond needs to win the referendum and negotiate the terms of independence successfully with the Westminster Government. Along the way he will have to find a solution to such difficult problems as Scotland's admission to membership of the EU. The most obvious way for a new country to be admitted under the EU Treaties at present would be by the consent of all Member States. However, other Member States seeking to discourage independence movements in parts of their territories may be unwilling to give such consent – for example the Spanish Government (with its eye on dampening ambitions for Catalonian independence).

Alternatively, the result of the referendum may simply become a mandate for a re-drawing of the boundaries of the existing constitutional settlement on Scottish devolution. It has long been suggested that the best result for the Scottish National Party would be to achieve "Devo Max" – a major expansion of the current areas in which the Scottish Parliament is permitted to legislate, without the full burdens of being solely responsible for Scotland's fortunes.

Is it conceivable that in this context the UK Government would permit its Scottish counterpart to take responsibility for administering the Scottish section of the UKCS and/or having a direct share in the tax revenues from its exploitation while Scotland was still part of the UK? Maybe it will depend on how good the prospects for English shale projects look in a couple of years!

Other notable developments in the UK oil and gas sector

New offshore oil licensing round

On 24 January 2014, DECC launched the 28th offshore licensing round. The announcement stressed the role played by the Strategic Environmental Assessment process in influencing the Government's decision as to which blocks should be made available. At the same time it noted that some of the areas currently withheld, such as the Moray Firth and Cardigan Bay, might become available in the future as more information about the potential impacts of offshore development on the marine environmental becomes available. Applications for licences are due in by 25 April 2014.

Decommissioning relief deeds

In 2013, the Government agreed to sign up to model form "decommissioning relief deeds" with those who may be liable for decommissioning costs. The effect of these agreements is to guarantee at current rates the tax relief available to such companies at the time of decommissioning. Where a company enters into a decommissioning relief deed, there will then be a need to make adjustments to the decommissioning security agreements so that security payments can be recalculated, thereby reducing security costs and freeing up capital.

Other tax measures

Two further oil and gas tax measures were announced with the Autumn Statement: reinvestment relief for pre-trading companies and changes to the substantial shareholding exemption. Both measures will form part of the Finance Act 2014 and take effect when it receives Royal Assent.

The first measure prevents a chargeable gain being subject to a corporation tax (CT) charge where an asset is disposed of in the course of oil and gas exploration and appraisal (E&A) activities and the proceeds are then used for the same purposes. To be eligible for it a company must operate such activities wholly outside the ring fence. The aim is to encourage investment in the UK and UKCS by allowing companies undertaking E&A activity, which have not started trading within the ring fence, to reinvest their profits back into the industry without a CT charge arising. This change, although it will apply onshore and offshore, seems to have been partly prompted by feedback on the shale gas tax relief consultation of 2013.

The second measure extends the scope of the Substantial Shareholding Exemption to treat a company as having held a substantial shareholding in a subsidiary being disposed of for the 12-month period before the disposal. To qualify, the subsidiary has to be using assets for oil and gas E&A activity that have been transferred from other group companies and meet the other conditions for the exemption. The aim is to remove a barrier to the transfer of assets from a group undertaking E&A activity in the oil and gas sector to another group in that sector that will use the licence in the trade of extracting oil or gas.

Compulsory stocking obligations

Back in April 2013, the Government published a consultation on whether to change the way in which the UK implements the central stocking obligations (CSOs) in the EU Oil Stocking Directive. At present, individual companies are directed to maintain stocks so as to fulfil the UK's obligations. The alternative approach, on which views were sought, would be to move to a system where a Central Stocking Entity, owned and operated by industry collectively, was responsible for holding the relevant stocks. Such a move might reduce burdens on individual operators, but so far the Government has not published or responded to the feedback that it has received on this consultation. A response must be likely at some point in the course of 2014. See Dentons' briefing on the CSO consultation.

Privatisation of the GPSS

The Energy Act 2013 received Royal Assent in December 2013. It includes provision to facilitate the privatisation of the extensive network of oil infrastructure known as the Government Pipeline and Storage System (GPSS). The GPSS is currently administered by the Oil and Pipelines Agency, a public corporation of the Ministry of Defence. Amongst other things, the GPSS supplies about 40% of the aviation fuel used in the UK (see Energy Act 2013 and the DECC policy brief on GPSS provisions). The relevant provisions have yet to be brought into force, but the proposed privatisation may well move ahead later in the year.

Following future developments

Many of the initiatives covered in this note are "work in progress", and 2014 may see the introduction of further new regulatory proposals as well. For information and commentary on the UK energy regulatory scene as it develops, subscribe to our new blog at www.TargetUKEnergy.com.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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If we decide to change our Terms & Conditions or Privacy Policy, we will post those changes on our site so our users are always aware of what information we collect, how we use it, and under what circumstances, if any, we disclose it. If at any point we decide to use personally identifiable information in a manner different from that stated at the time it was collected, we will notify users by way of an email. Users will have a choice as to whether or not we use their information in this different manner. We will use information in accordance with the privacy policy under which the information was collected.

How to contact Mondaq

You can contact us with comments or queries at enquiries@mondaq.com.

If for some reason you believe Mondaq Ltd. has not adhered to these principles, please notify us by e-mail at problems@mondaq.com and we will use commercially reasonable efforts to determine and correct the problem promptly.