There is a lot of chatter, especially amongst politicians in both the US and Europe, about windfall taxes, with the targets being energy companies, electric & gas companies (i.e. utilities) and banks. A windfall tax is an extra tax over and above the standard corporate tax on the profits of certain companies. A number of European countries have already introduced or are considering introducing windfall taxes on energy and / or utility companies, including the U.K., as you can see in the schematic below from Tax Foundation.
In my opinion, windfall taxes are nothing more than a political tool which make little economic sense. Politicians like to go on and on about the high profitability of certain sectors, especially when these sectors are often the ones most loathed by people in general. This makes these sectors even easier targets. To really ramp up the emotion and extend the populist appeal, advocates of windfall taxes like to attribute these so-called “excess profits” to unfortunate events like the pandemic or to sanctions related to Russia’s illegal invasion of Ukraine. There are so many reasons that this is wrong that I can’t cover them all, although I will touch on a few of them in the sections on banks and energy companies further below.
I think windfall taxes are a terrible idea economically for two reasons:
Windfall taxes are tantamount to the government seizure of corporate assets, which rightly belong to the company and its stakeholders, including employees, shareholders and bond holders. Stock and bond investors invest in a company by developing a narrative around an attractive going-in price, which in turn is based on the expected corporate performance (including cash flow generation) and the context, meaning the competitive, regulatory, political and tax overlay. These circumstances can of course change over time but destroying value by pulling the rug out from under investors via a windfall tax is particularly nasty and unfair. Also keep in mind that in any event, existing corporate tax revenues are tied to profitability, so record profits deliver record corporate tax revenues to governments without a windfall tax. Why is that not enough?
Windfall taxes skew the decisions of management, affecting how and where they choose to invest for the future. Think about it – if country A imposes a windfall tax on a company’s profits, then it will probably instead invest in country B, where there is no windfall tax. When a government can unilaterally decide to impose a windfall tax on certain companies or sectors, it has short-term implications in terms of higher tax receipts, but it also has long-term implications on both future investment and trust. The short-term implications of a windfall tax from a company’s perspective are that it has less cash to hire new employees, expand into new businesses, invest in new production technology / capacity (including alternative energy in the case of oil & gas companies), reward shareholders for “hanging in there during the darkest hours”, or – most likely – some combination of all of these. The long-term effects are that companies will invest for the future elsewhere.
My view generally is that windfall taxes are unfair and lead to the misallocation of resources within companies or sectors more broadly. Long-term, my instinct is that windfall taxes will prove counterproductive even though they might be politically appealing.
I favour minimal government intervention into business. History has shown time and time again that in most instances, competitive forces and minimal regulation lead to a more efficient allocation of capital. I am less comfortable speaking about European utilities because each country has its own regulations, etc. However, I will speak more specifically about banking and energy companies, the sectors that seem to be most targeted by governments at the moment.
Banking
Suggesting an excise tax on banks because they have benefitted from higher interest rates is unfair and, in my opinion, completely wrong since central banks manufactured a monetary policy overlay that has been poor for banks since the GFC.
Banks were required to build enormous capital reserves, eroding returns on invested capital for shareholders, in order to make them safer (regulatory requirements, and fair enough perhaps given the “misbehaviour” of banks prior to GFC), and
Banks have been in an environment characterised by artificially low interest rates and flat yield curves manufactured by central banks, which have undertaken and maintained unconventional accommodative monetary policies since the GFC, until the recent spike in inflation.
The banking system in the US and many other countries faced systematic failure during the GFC only to be rescued by governments and central banks, but this rescue also of course served the interests of politicians and the general public at the time. Perhaps the discussion about windfall taxes on banks now that interest rates are rising is considered payback, but that doesn’t make sense to me. Banks obviously do better when interest rates are higher, especially smaller US regional banks and most European banks, both of which are weak in investment banking and rely mainly on retail / spread lending. The Fed, ECB and BoE had until early this year anchored overnight bank borrowing / deposit rates around 0%, and that’s not an environment in which most banks shine. Banking is also inherently cyclical since banks experience credit losses on loans during economic downturns. It is fairly obvious now that the US economy will slow and probably dip into a recession, the UK is in a recession already, and the EU is heading in that direction quickly. Banks see this coming, and many increased their loan loss reserves in the quarter that just ended as a result. Global universal banks – mostly American – have more diversified revenue streams but are also facing headwinds as far as revenues from investment banking and wealth management. Kicking banks because they are experiencing a few good quarters as monetary policy “normalises” by applying a windfall tax just as the clouds on the horizon start to darken is both unfair and ill-advised for obvious reasons, but it is especially unfair to shareholders that have muddled through years of uninspiring profits and share performance.
Energy companies
Both large integrated (majors) and independent oil and gas companies have been facing pressure for years from all directions. As the world moves toward clean energy, oil & gas companies will need to radically change their business models or cease to exist. To transform a large major oil company is like turning an ocean liner – it will take a lot of time and precise navigational skills. All of the majors have made commitments though in this respect. Even so, they are constantly maligned for producing what global consumers are begging for (i.e. fossil fuels) to survive until the transition to clean energy is complete. You could easily argue that European governments set themselves up for the very predicament that they find themselves in today because they allowed themselves to become overly reliant on cheap Russian gas. How can European governments even think of suggesting windfall taxes on energy companies given that they willingly walked right down the garden path?
Oil & gas companies are in the early phases of dealing with the secular trend requiring significant shifts in strategy and billions upon billions of dollars of new investment in alternative energy sources. As they are dealing with this secular change, they also must endure sharp swings in profitability due to economic cycles. Oil prices go up and down over well-defined cycles. When prices of oil fall below a company’ lifting costs, then the company either has enough cash and access to financing to survive these periods, or they go out of business. However, when capacity is under pressure and demand is strong (like now), oil prices rise and profits increase. This is the day in the sun that seems well deserved for those companies that have weathered the difficult periods. High profits of course provide governments with significantly higher tax revenues, and also provide energy companies with investment capital to fund their future. With the secular trend favouring investment in alternative sources of energy – and clearly seeing a slowing global economy ahead – energy companies have made the decision to invest less in fossil fuel capacity. Instead of being celebrated, they are being maligned by governments for underinvesting and returning money to shareholders which – as a reminder – are the owners of these companies.
The sudden drop in demand in the early stages of the pandemic caused oil prices to plummet, even becoming negative for a day in April 2020. The table below from FRED shows the trend of WTI crude prices since mid-2019, prior to the pandemic.
As the graph illustrates, the price of WTI crude ended 2021 (period to the invasion) at $75.33/bbl, spiked post-invasion to $123.64/bbl on March 8 (2022), and has since fallen back to around $89/bbl. This is higher than the historical average, but certainly the froth of the war has come off as markets acclimate to a post-war environment without Russian oi & gas.
It seems fairly clear that demand will likely wane as the global economy slows. This will lead to lower prices, even though OPEC+ is doing its best to concurrently curtail supply. Assuming oil will stay at elevated levels like this has proven to be a fool’s game in the past, so I doubt these dynamics will persist. The recent price history, coupled with the historic cycles in performance and the secular overlay, all suggest that a windfall tax given “high prices at the pump” might be considered good politics but it is a very bad business idea.
Conclusion
The P/E’s of banks in Europe (iShares STOXX 600 banks, 8.0x TTM), the US (KRE at 10.7x forward) and energy companies (XLE at 8.9x forward ) all demonstrate the lack of broad appeal of these sectors in spite of “record revenues due to the pandemic or the war in Ukraine”. (Note that the forward P/E of the S&P 500 index SPDR is 16.7x.) The low valuations for banks and energy companies might at least partially reflect the overhang of potential windfall taxes. My message to politicians is this: if you are in a country with free markets, let investors direct capital without government interference to those companies that they think will be the most attractive in terms of deploying this capital in their business and sector. Certainly, they must be better equipped at doing this than technocrats sitting in Washington, Brussels or London. When politicians de factosuggest they know more about how to run a business than experienced industry professionals, I get especially nervous.
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