A Fiscal Framework for Offshore Oil and Gas Activities in Romania

The discovery in 2012 of a significant natural gas reservoir in the Romanian offshore sector of the Black Sea, followed by other encouraging findings, offers an opportunity for the Romanian government to update the fiscal legislation concerning taxation and royalties for oil and gas activities in order to attract more investment in this vital sector. This study analyses the opportunity of replacing the current revenue-based royalties that apply to all types of oil and gas projects with a resource-rent tax (RRT) in the offshore sector. A RRT is the most efficient way for the government to collect a share of the rents or surplus generated by the exploitation of non-renewable resources. However it can be difficult to implement a RRT for small extraction projects that are hard to monitor. We recommend that the new legislation distinguish between conventional onshore and offshore projects, primarily because offshore production entails larger investment expenditures, higher risks, and longer times to build and then to recover costs, than conventional onshore projects. A resource rent tax (RRT) should be adopted for offshore oil and gas projects because it could provide greater incentives to invest in exploration and development than royalties based on revenues from oil and gas production. Under a resource rent tax, a firm can deduct all of its operating and capital expenditures from its current revenues from a project.  If the operating and capital expenditures exceed current revenues, which will generally be the case in first few years of a project, the firm can carry these expenditures forward at a specified interest rate and deduct them from future revenues.  The base for a resource rent tax is the difference between the present value of the revenue stream from a project and the present value of its operating and capital expenditures or, in other words, the present value of the economic rent generated by the project. The average effective tax and royalty rate (AETRR) is the share of the economic rent generated by a project that is captured by the government through taxes and royalties. The marginal effective tax and royalty rate (METRR) measures in percentage terms the wedge that the tax and royalty system drives between the gross-of-tax rate of return earned by a marginal investment and the net-of-tax rate of return.  The METRR is a measure of the disincentives to invest in oil and gas projects that are created by the tax and royalty system. We estimate that replacing the current 13 per cent royalty with a 45 per cent RRT would maintain the current AETRR and reduce the METRR for exploration and development activities in the Romania offshore sector by more than 12 percentage points, from approximately 18 per cent to less than six per cent, resulting in a significant reduction in the distortions created by the tax and royalty system.  This switch would generate approximately the same, or perhaps even more, revenue for the Romanian government, as our analysis of a prototype offshore natural gas project illustrates. If it adopts a RRT for the offshore projects, the Romanian government should consider the adoption of a RRT rate that varies with the price of oil or the price of natural gas. The variable RRT rate means that, as the price of the resource increases and more economic rent is generated, the government is able to capture a larger share of a larger pie. Having an explicit formula for how the RRT rate will vary with the price of the resource also reduces uncertainty about future RRT rates if prices are different in the future. In order to smooth its revenue stream from offshore projects and to improve public acceptance of the adoption of a resource rent tax, the Romanian governments could retain a royalty on revenues from offshore production in the initial years of a project, which would be credited against the project’s future RRT liabilities. This would change the time profile of the government’s revenue stream, relative to a pure RRT, but the present value of the revenue stream would remain the same. Another complimentary fiscal instrument that can be used to achieve a similar goal as the RRT is to award exploration rights through competitive auctions. The more geological information is available to potential investors, the closer their bids will reflect the expected rent from developing the resource, allowing the government to capture without distortions a significant portion of the rents generated by oil and gas extraction projects.