Fuel Duty, the Oil Price and the Future of Mankind

by George Hatjoullis

The crude oil price has fallen by around 40% since the summer. It has not yet found a bottom so a further fall is likely. Petrol prices at the pump, in contrast, have fallen more like 5%. In part this reflects the time it takes for lower crude prices to impact petrol prices but it also reflects the structure of petrol prices. Every litre of petrol (or diesel) comes with a 57.95p fuel tax to the Treasury. Five pence (or less) goes to the retailer and only then does the petrol cost get added. VAT is then charged on the sum of the fuel duty, retail margin and petrol cost to get the price at the pump. Clearly, even if the cost of petrol dropped by 40% (which is unlikely) the price at the pump will fall by less than 40% because fuel duty is not connected to the petrol cost. It is a state decision. The Autumn Statement did not result in any change in fuel duty.

The failure to change fuel duty was good politics, with an election so close. The Conservative Party cannot afford to upset ‘white van’ man (or woman) any further. It is however very poor economics. Our friend the incidence of taxation comes into play again. In the short-term, the supply of oil and, to lesser extent, petrol is very inelastic. Pumps keep pumping and refineries keep refining (though with some scope to vary the ‘shape of the barrel’). Part of any increase in fuel duty is thus, in the short-term, absorbed by the producers. How much is absorbed rather depends on the shape of the consumer demand curve but the amount of petrol bought and sold does not typically vary that much. A rise in fuel duty pretty much goes straight into the exchequer. The government needs tax revenue badly and this would be a good (in economic terms) way to raise it especially as in part it will be paid for by the producers through even lower petrol costs.

In the long run both supply and demand curves are more elastic. The fall in crude prices is making those that invested in high marginal cost sources of fossil fuels (e.g. through such technologies as fracking) nervous. If crude oil prices do not recover and stabilise then their investments will prove to have been unwise. Moreover, anyone considering such investments may be having second thoughts. Of course long-term investments cannot be based on extrapolation of spot prices so long-term forecasts must be generated. I spent a few years generating such forecasts in the corporate planning department of a leading british oil company many years ago and I observed then that these forecasts always substantially overestimate the long run achievable price. Higher prices bring on new supplies much quicker than the planners always assume and consumers find ways to economise much more effectively than is assumed.

The use of fossil fuels as a source of energy is anachronistic. The supplies are by definition finite. The emissions appear to be altering the planet’s climate patterns with potentially catastrophic consequences. The distribution of supplies across the globe is uneven and has already had catastrophic consequences for some countries. The planet needs to desist from using fossil residues as fuel as soon as possible. In a free market system, price has a key role to play in this move.

The period of high prices has brought on new supplies of fossil fuels but has also encouraged the development and adoption of economising technologies and alternative energies. A dramatic and sustained fall in fossil fuel prices will slow if not reverse these process. One way around this dilemma is through the tax system. If the governments of consumer nations systematically and punitively tax the use of fossil residues as fuel the price to consumers can be held higher, thus encouraging the adoption of economising technologies (e.g. hybrid cars). It will also encourage investment in, at present, expensive alternatives. It is hoped that through investment and research these expensive alternatives will eventually cheapen and become sufficiently plentiful to usurp the use of fossil residues. In the meantime the tax revenues so generated can be used to encourage the switch and will to a large extent be borne by the producers of fossil fuels. Holding fuel duty constant at the moment may have been a good short-term election ploy but from almost any other perspective is really quite stupid.

The global objective should be to develop technologies that enable mankind to derive energy and fuels from clean, safe and sustainable sources. It should also seek to make these technologies globally available. I can think of nothing that will do more to raise living standards everywhere (except maybe water availability) than widespread distribution of energy. So many of the problems of the day (migration, war) seem to stem from these inequalities. It is odd that a simple thing like raising fuel duty can take us down the road to a better future.