Scotland's Independent Expert Commission on Oil and Gas: report

3. Stewardship: A Road Map To TVA

Key Messages:

• An informed government strategy with a dual focus on achieving MER and generating maximum TVA: setting the high level agenda for good stewardship
• Creating a positive sentiment for attracting investment and tackling the impediments to investment
• A voluntary collaborative partnership between industry, government and the new Regulator
• Proactively developing the capability and competitiveness of the supply chain

A Dual Focus: MER and TVA

1. The UKCS has produced 42 Bboe to date and there is potential for a further 24 Bboe or more still to be recovered. In recognition of the technical challenge and higher cost of developing these additional resources, and of the potential value generated for the broader economy, the Commission believes that a dual focus for future policy and stewardship should be adopted. That policy should be:

a. built with the explicit aim of Maximising Economic Recovery, and

b. constructed so that government and society benefit from the TVA generated by industry.

2. Developing innovative policies and practices that not only attract the required investment but also enable the development of the technologies and capabilities in the industry will be essential to underpinning the achievement of this dual policy focus.

Box 3: Total Value Added: ' TVA'

• A healthy UKCS is a pre-condition for maximising the potential for the supply chain. A key recommendation of this report is therefore the need to procure a clearer understanding of the TVA created for the overall economy by the oil and gas industry. This will enable a better understanding of the interaction between, and therefore the management of, tax and regulation - in the context of the overall generation of value to the broader economy.
• TVA is the sum of 3 components namely (1) that derived directly from the UKCS in the wages, profits and related taxes from the production activity, (2) the indirect contribution from wages, profits and taxes of the supply chain, and (3) the extra induced activity of the supply chain, in export markets and other non-oil sectors, from UKCS activity in the form of further wages, profits and taxes. TVA is therefore a measure of the maximum value added by the whole industry to the economy. Optimising this should be the objective of Government strategy.
• Whilst energy security, balance of trade, exports, R&D and technology development all contribute to the overall picture, corporate and employment taxes, both direct and indirect, also generate substantial value for the economy. Furthermore, if the UK supply chain, both indigenous and inward invested, develops the technologies and capabilities to increase the total extraction of hydrocarbons from the UKCS, the long term value added to the economy will last well beyond the cessation of production in the UKCS, by taking new technologies, services and skills across the globe.
• This report advocates using fiscal, regulatory and licensing levers to maximise the overall economic recovery ( MER) and ultimately to maximise the TVA generated from the remaining national resource.

3. Implementing the Wood Review in the context of TVA will only be achieved through a more collaborative approach between Government, the new Regulator and all parts of the industry. This will greatly change the perception of the sector's economic and societal contribution, and embed a dynamic energy industry which will continue to contribute sustainable value to the economy long after UKCS production has ceased.

4. Developing an understanding of where and how TVA arises, and how it can be maximised is vital to informing and justifying Government policy and practice. There are a range of potential benefits from developing a policy framework on this basis, including:

• Improving the balance of trade - policy options that maintain domestic production and encourage oil and gas exploration and development will help to reduce net imports and could be a key feature of any import replacement strategy. This will improve the balance of trade and subsequently the balance of payments position;
• Improving the reach and reputation of domestic companies - extending the life and boosting the production profile of the UKCS will provide a platform for indigenous oil and gas companies within the supply chain to expand their international activity and boost the reputation and position of the industry globally;
• Enhancing the contribution that the sector makes to the economy - currently the Government is perceived to focus primarily on taxation and payments to HM Treasury, rather than considering the breadth of impact of the industry. With a focus on TVA it will ensure that the contribution the sector makes through direct, indirect and induced employment; through improved skills provision and through the economic impact of the supply chain will be reflected in the policy approach;
• Improving Energy Security, Affordability and Decarbonisation - as domestic production gradually declines the UK has moved from an energy independent nation to one which relies on global imports to meet energy demand. Careful stewardship of the oil and gas industry with a focus on TVA will ensure that the contribution from domestic production to energy security and the energy trilemma is maximised while supporting the transition to a low carbon economy; and
• Improving R&D, technological development and innovation - The cost of innovation and R&D is high and government support could drive innovation and help bring products to market more cost effectively. These products would not only improve UKCS prospectivity, but through the development of transferable technology these products could be exported globally. This would allow the development of domestic centres of excellence in strategically important areas. Total value from this innovation needs to be measured more robustly and regularly monitored, in order to better inform government decision making.

A Road Map to TVA

5. In order to achieve the goals of MER and TVA, a Road Map must be produced by Government, clearly setting out the policies and the manner in which the sector will be governed and managed.

6. The Road Map set by Government must ensure that any changes to the fiscal, regulatory or licensing regimes are wholly cognisant of the overall impact on value to the economy, not only short-term considerations of direct tax receipts from oil and gas production.

7. The Road Map should encompass a strategy for the delivery of MER, including the development of the skills, capability, innovation and technology required to achieve an overall increase in the capability and competitiveness of the indigenous supply chain.

8. As a basis for a new model of proactive stewardship the road map must seek to eliminate or mitigate the current investment challenges and look at actions, structures and changes that are needed to facilitate the following;

• Inputs: Clear phasing of actions to achieve short-term value as well as long-term results, and a more sustainable future;
• Outputs: Sustained investment across all development opportunities in the UKCS;
• Outcome: MER plus maximum TVA: optimal production of oil and gas with optimal value generated for the economy; and
• Impact: Sustainable industry generating significant value post-production in UKCS.

9. In doing so the Road Map must make clear the Government's strategy and approach in how it intends to use the levers available to it, namely:

• Stewardship;
• The Fiscal Regime;
• Regulation; and
• Licensing.

10. The recommendations within this report have been structured around these key levers of government, with a view to achieving MER and maximising the TVA from the industry - with a particular focus being placed on Technology and Innovation, Skills and Decommissioning as the key areas which must be developed and managed effectively to enable delivery of this overall strategy.

11. The innovative capability of the supply chain is crucial to delivering both MER and TVA. Government has a key role as both a driver and catalyst to ensure the Centres of Excellence that underpin the technology and skills development in the supply chain form the compelling reason for those companies to remain anchored in the UK over the long term. The development of existing, or the creation of new, Centres of Excellence must include the emerging opportunity in Decommissioning.

12. The Road Map must focus on the key levers outlined above and on defining the roles and responsibilities of Government, the new Regulator and all parts of the industry, to produce a transparent and responsive framework. This will provide a mechanism to ensure that Government is better equipped to adapt to the changing commercial environment in the UKCS and it will provide greater certainty for the industry as to Government's priorities and values.

13. If this is developed with input from industry, it will have the required credibility and sustainability to have a real impact on the legacy of the UKCS.

Understanding TVA

14. The Commission has found it difficult to source adequate data reliably to evaluate TVA in all its aspects. Government and industry should work together to develop the data that would allow a new understanding of TVA. This will in turn inform how the historical focus on Production Profits tax revenue can be re-balanced and better managed to ensure maximum TVA is achieved.

15. Recent assessments have indicated that the value generated by the supply chain is significantly greater than previously estimated. EY published two reports, jointly commissioned by OGUK, UK and Scottish Governments, showing direct UK supply chain turnover in 2012 to be in the region of £35 billion, representing year on year growth over the last 5 years. ^[26] The EY analysis also found that 42% of this turnover was from exports, a percentage which has remained steady over the last five years ^[27] .

16. The Scottish Enterprise survey on international activity shows that the total international sales from Scotland's oil and gas supply chain and overseas subsidiaries grew to £10 billion in 2012-13. ^[28]

17. In Scotland, international activity now accounts for over half of total oil and gas supply chain sales, demonstrating that the industry is just as strong internationally as it is domestically, and that it continues to contribute substantial additional value to the economy as a result.

18. However, it is recognised that even these detailed studies represent an understatement of this valuable economic contribution. In applying qualifying criteria and assumptions these figures represent an unknown but significant discount on aspects of the value generated by the industry as a whole.

19. A deep understanding of how this vibrant and vital oil and gas sector operates is needed in order to build and maintain its ability to generate maximum TVA. Understanding the value chain from exploration to decommissioning, and the significant role that human and financial capability plays in driving its success, is a vital pre-cursor to understanding how and why MER must be delivered.

A 5 year Strategy

20. The Road Map must set the high level agenda for good stewardship of the UKCS, expedited through the adoption of a rolling 5 year strategy, and staged in line with a comprehensive evaluation of the remaining asset value of the UKCS.

21. In 2012 the Scottish Government launched its Oil and Gas Industrial Strategy, and in 2013, the UK launched its own. These strategies have contributed substantially in the last two years to the development of the supply chain, domestically and internationally and have sought to address issues the industry are facing around skills and technology.

22. What is now needed is a much more coherent, joint approach, recognising the interdependencies that exist in the sector, with the supply chain split almost equally between Scotland and England ^[29] . A coherent strategy, focussed and targeted in a way which recognises the differing environments of the five areas of the UKCS: Southern North Sea ( SNS), Central North Sea ( CNS), Northern North Sea ( NNS), West of Shetland ( WofS), and Irish Sea ( IS) - and which distinguishes between the near and long-term prospects.

23. The Road Map must determine the areas for action which can achieve short-term gain and those which will provide longer term sustainability through investment and planning. The following areas for action must be prioritised:

• Exploration and Production: the first priority must be to generate increased investment in order to increase exploration activity, which will in turn boost production;
• Infrastructure: Access to and investment in infrastructure needs to be tackled concurrently with increased investment in production, to sustain and support continuing activity;
• The Supply Chain: the supply chain capability and performance in innovation and technology development must be placed on a different footing, allowing it to adequately respond to the needs of the exploration and production market; and
• Decommissioning: the decommissioning market represents a huge economic opportunity for the supply chain and it is an area in which the UK taxpayer has significant equity. This leaves an unarguable need to develop both efficient and effective capability and the ability to reduce costs for the operators and the taxpayer.

24. The 5 year strategy must be framed within the context of:

• MER and TVA by creating a vibrant oil and gas sector that creates sustainable wealth, based on an increasingly diverse investor base;
• The intrinsic differences in the commerciality and value drivers of the various stages of the Exploration and Production value chain through exploration, development and production and how these apply to the economic sectors of the UKCS;
• The commercial considerations made by the international oil and gas sector in evaluating investments within the UKCS versus other global opportunities, and the impact of designing fiscal and regulatory regimes that encourage domestic and inward investment; and
• The need for investment in the technology and skills required in the UK both within oil and gas companies and the broader supply chain.

25. In pursuit of this strategy a voluntary collaborative partnership environment must be established. Investors must be incentivised to work collaboratively to achieve common objectives and Government will retain the ability to exercise legal powers through fiscal, regulatory or licensing levers if obligations are not met as agreed and in the interests of MER and TVA.

26. Government and the new Regulator must therefore develop a means for establishing working partnerships with investors with common objectives that deliver full economic benefit to the nation and a realistic expectation of a reasonable return for operators. The regime must be managed in a sustainable way, ensuring the stable, predictable regime required for investment even in marginal resources that will deliver additional value.

Recommendation 1: A Road Map must be established quickly for the future of the UKCS ensuring the implementation of a clear strategy to maximise TVA generation for the nation.

Tackling the impediments to investment

27. Government must be proactive in attracting higher levels of appropriate long-term investment into the UKCS, to ensure that the level of production and recovery of hydrocarbons delivers maximum TVA to the economy.

28. This investment is required in all areas of the industry; exploration, development, production, infrastructure, decommissioning and the supply chain - enabling the development of sustainable capability, skills, innovation, and technology development.

29. The assessment of what is 'economic' recovery must be reviewed in light of potential TVA. Proactive stewardship by the new Regulator must not only tackle the impediments to investment but also assist Government in ensuring the maximisation of TVA through providing advice in relation to the necessary investment in, and development of, skills, technology and innovation.

30. The Road Map must seek to create a new, more positive sentiment, that the UKCS is:

'Seeking investment and open for business'

31. This sentiment should be enacted with a clear focus on recognising the contribution of those who are prepared to work in partnership with Government and the new Regulator, bringing benefits to the nation from this natural resource.

32. Whilst it is still possible to point to levels of activity and investment that are encouraging, less positive indicators in areas such as exploration and production efficiency must be reversed if the basin is to achieve its potential. The sentiment towards future, sustained investment in the UKCS is not as positive as might be expected from the record levels of investment being reported.

33. The current regulatory and fiscal regimes were relevant for the period when the UKCS had large, projects that attracted investment funds in the globally competitive market. The investment environment in the UKCS is undergoing transformative change and the nature of the regulatory and fiscal regime going forward must do more to attract smaller and specialised companies to invest in the UKCS.

34. A new regime must be established. A tax and regulatory regime which does not inhibit investment and positively drives the attainment of the maximum economic potential from the UKCS. This has the potential to create a new positive sentiment, with Government and the new Regulator sending the right signals to investors and declaring a clear purpose and intent which has resonance internationally. This message must make clear an intent for a predictable, investable, clear and competitive regime.

35. The new Regulator, in support of MER, should be responsible for creating the appropriate investment environment and for the economic production of oil and gas, with the industry and Government working together to make the most of that opportunity.

Recommendation 2: Government and the new Regulator must be proactive in tackling the impediments to sustained investment, creating the positive sentiment for attracting investment and facilitating its enactment, implementation and embodiment.

The Supply Chain

36. In support of the Government's dual policy approach there is a need to foster a strong competitive supply chain which is capable and sustainable.

37. Much of the focus up until now has been on taxation from production and that has been a key driver in setting the relationship between oil and gas operators and the Government. The reality now is that the prospect of generating maximum TVA requires a change of focus and the assessment of value has to include all areas where value is generated.

38. It is estimated that around 450,000 jobs are supported by the UKCS through direct and indirect employment. For every job in an oil and gas company a further three jobs are created in service companies or ancillary sectors. The importance of incentivising investment in oil and gas in the UKCS therefore goes beyond the oil and gas companies, to every facet of the wider supply chain.

39. Expertise developed during the early stages of the UKCS is now being applied to new frontiers across the world. Rising to new global challenges will allow our indigenous oil and gas businesses to be world leaders in key parts of the global supply chain.

40. There needs to be a real focus on developing, establishing and anchoring in the UK the supply chain that will deliver the technologies, capabilities and skills needed to meet these technical challenges. Such a supply chain has the potential to thrive long after production has ceased.

41. This will only be achieved if, along with this commitment to Maximise Economic Recovery, there is well managed on-going investment in creating centres of excellence in key areas of technology and know-how around which a technically superior core of companies is able to compete and thrive supporting the oil and gas industry worldwide.

42. This indigenous supply chain should be fostered and championed irrespective of ownership. Sustainable value can be achieved through developing domestically owned capabilities and strengths, as well as securing the UKCS as a preferred location for the international industry to operate due to the Centres of Excellence delivering the skills, technology development and innovation.

Recommendation 3: Government should play a proactive role in developing the capability and competitiveness of the supply chain with advice and support from the Regulator.

Box 4: Value Creation in Norway

For evidence that a strategic, long-term approach to stewardship in the UKCS, focussed on the generation of value, is needed it is helpful to look to Norway.

The Norwegian Oil and Gas industry is internationally competitive in almost all parts of the oil and gas value chain - Norway has become a global hub for oil and gas activity, with a particular focus on pioneering technology. The over-arching goal of the Norwegian authorities has been value creation for the nation. Value creation has been maximised though the adoption of a dual policy of attracting global oil and gas companies, and stimulating the development of competence and capital. ^[30]

A key feature of the Norwegian regime has been the influential role which the two National Oil Companies, Statoil and Petoro AS, play in the sector, and the value created for the nation through the state ownership of these companies.

Since production started on the Norwegian continental shelf in the early 1970s, the industry has contributed approximately NOK 11,000 billion to the Norwegian GDP, measured in 2013 NOK. ^[31] This has helped to create economic security and jobs across Norway.

Value creation per employee is estimated to range from NOK 1.2 million for suppliers to NOK 6.5 million for operators. In comparison, value creation per employee in the Tourism industry in Norway is NOK 0.4 million ^[32] .

Minister for Petroleum and Energy in Norway, Tord Lien, sums this up in the latest Norwegian Ministry 'Facts 2014' publication:

"The objective of Norwegian petroleum policy is to generate the greatest possible value from the resources on the Norwegian shelf in the best interest of the Norwegian society. This will require the best efforts of everyone involved. Within a clear regulatory framework, we will work together in a smarter, more efficient and well organised manner. We must develop knowledge, innovation and new technology. Then, and only then, will we be equipped for the future." ^[33]

As a maturing province Norwegian policy makers are now faced with similar challenges as exist in the UKCS. In this context public policy must continue to focus on ensuring the industry makes a sustainable contribution to value creation in Norway.