The status of the UK’s shale revolution

October 2014  |  FEATURE  |  SECTOR ANALYSIS

Financier Worldwide Magazine

The discovery of vast quantities of both shale gas and oil in the US has proved revolutionary for the country’s energy sector. In July it was reported that the US has surpassed both Russia and Saudi Arabia to become the world’s single largest oil producer, with daily output now exceeding 11 million barrels.

Hopes are high for a similar revolution in the UK, where recently discovered shale deposits have sparked debate over the opportunities and pitfalls presented by hydraulic fracturing, or fracking. According to a study by the British Geological survey, there is approximately 1300 trillion cubic feet of natural gas in northern and central England. It is believed that just 10 percent of those shale resources would be sufficient to supply the country with gas for almost half a century. The quantity of shale gas quoted in the British Geological study have provided a boost to industry advocates as it is significantly higher than previous assessments. Other estimates placed the figure for the entire UK at nearer 2000 trillion cubic feet.

Some analysts believe that, much as it has done for the US, fracking could have a transformative effect on the UK energy sector. With a number of the UK’s domestic power sources undergoing decommissioning and significant carbon reduction targets looming large on the landscape, it is possible that shale gas could provide some much needed answers to the ongoing question of British energy production. Accordingly, Prime Minister David Cameron and a number of other prominent politicians have championed the case for shale gas. Mr Cameron believes that fracking represents a “real opportunity” for Britain going forward.

The need for countries like the UK to develop new, clean and sustainable sources of energy is urgent, and whether the UK will be able to exploit the resources of shale gas found within its borders hinges on a number of important factors. For the shale revolution to take hold in the UK, the extraction of gas must first be possible – only a fraction of the resources laying underground can be recovered with existing technologies – but, crucially, it must also be both economically and environmentally viable.

Although to date the only drilling to take place in the UK has been exploratory, should the resources be as considerable as the estimates suggest, some believe the country may be poised for a US style revolution. “There is no reason to think otherwise,” says Garry Pegg, the managing partner of King & Spalding LLP’s London office. “We have shales in abundance in the UK and if they can be appraised and developed economically, the prospects are exciting. Some of us remember the ‘dash for gas’ around 2002. Shale could trigger the same levels of activity, but right across the board, not just among the electricity industry, as was the case 10 or more years ago.”

Despite optimism that shale gas could revolutionise the domestic energy industry, environmental questions remain about the appropriateness of fracking. Shale gas has many vocal detractors – environmental lobbyists such as Friends of the Earth (FoE) have been outspoken about the downsides of the process. According to lobbyists, fracking poses an enormous risk to both the environment and the people living in the vicinity of shale gas sites. The UK government is taking on board such concerns, having announced in July that companies looking to bid for licences in certain prestige areas such as National Parks, Areas of Outstanding Natural Beauty and World Heritage Sites would only be permitted to do so in “exceptional circumstances”.

Away from the environmental issue, however, the scale of the impact that shale could have in the UK is also uncertain. “The exploitation of domestic shale gas could contribute to the UK’s energy security. But even in the most optimistic scenario, shale gas might, at best, compensate for the depletion of domestic reserves of conventional gas,” says Samuela Bassi, a policy analyst at the Grantham Research Institute on Climate Change and the Environment at the London School of Economics and Political Science. “Gas imports are unlikely to decrease, and UK prices will remain largely driven by the European wholesale market. Furthermore, the shale gas industry could take a couple of decades to reach maturity. The UK is committed to decarbonising electricity generation by 2030, after which gas could only be used on a wide scale in power plants equipped with carbon capture and storage technology.”

Unsurprisingly for an undertaking such as the granting of exploratory and drilling licences, there are a number regulatory issues associated with the exploitation of shale gas. Health and safety issues in particular must be paramount for any firm bidding for licences. Accordingly, it is the responsibility of regulatory bodies to ensure that standards are met and maintained. Thankfully, from a regulatory standpoint, much of the hard work in the UK has already been done. “The critical period has already passed,” says Mr Pegg. “In the first quarter of 2013, the government announced its regulatory responses for the recommencement of UK shale gas exploitation. The Department of Energy and Climate Change (DECC) and its predecessors have been remarkably consistent and I think successful over the years in their approach to this kind of issue, from Piper Alpha and beyond. DECC seems to place the highest premium on HSE considerations, and as such will analyse issues with the highest level of technical scrutiny, and implement regulations and change as appropriate without being swayed by political or public sentiment.”

Indeed, considerable work has already been done to ensure that appropriate standards are in place, with the government initiating a regulatory regime which in some respects far exceeds the minimum EU recommendations recently released. “Exploration and production should be subject to strict regulation in order to keep environmental impacts to a minimum,” notes Ms Bassi. “As the International Energy Agency has pointed out, the shale gas industry will need to obtain a ‘social licence to operate’ in order to satisfy public concerns about its environmental and social impacts. This will require robust policies to minimise visual impacts and maintain strict environmental, health and safety standards in the production process.” It seems likely that the EU will revisit its regulatory recommendations in 2015; meanwhile, companies looking to operate in the UK should ensure that they strictly adhere to the guideline set out by the DECC and the UK Onshore Operators Group (UKOOG) if they wish to maintain their social licences moving forward.

In light of criticism from within the oil & gas industry, about the labyrinthine planning regulations imposed on firms applying for drilling licences, the government has pledged to relax a number of regulations. Furthermore, the UK will also be offering tax breaks to firms looking to drill. From an investment standpoint, these tax breaks could prove vital. Under new plans, the tax rate for initial profits made by shale explorers will be roughly halved – enabling companies to save an extra 24p in tax for every £1 they spend on the project. By offering tax breaks of this nature, the government hopes to create an effective tax rate for the shale gas projects lower than in the US, and one of the most competitive in Europe. The new regime has been structured so that when a firm starts making taxable profits from selling gas, it will be taxed at 30 percent rather than the standard 62 percent. This lower tax allowance lasts until such time as the company’s taxable profits equal 75 percent of the capital spent developing a project. This move is expected to create thousands of jobs, reduce energy bills and attract billions of pounds of investment in the UK in the coming years. The UK’s nascent shale industry has already attracted the attention of a number of parties both domestic and international. British exploration firms such as IGas Energy Plc and Cuadrilla Resources Ltd, as well as France’s Total, have all been either linked with investment in the sector or have made concrete commitments. For Mr Pegg, the new tax regime is a continuation of the UK’s open stance on oil and gas investment. “Successive UK governments have shown great dexterity over the years in constantly monitoring and recalibrating the applicable fiscal regime to encourage upstream investment in the United Kingdom Continental Shelf. I have no reason to think this government will be any less successful regarding shale gas exploration,” he says.

Offering tax incentives to firms hoping to explore the UK comes as the country is competing with Poland to lead European development in the industry. For Ms Bassi, the need for more certainty over the actual amount of UK reserves may be one of the factors spurring the government to grant fiscal support. “As the UK shale gas potential is uncertain, companies may need tax breaks and other incentives to carry out exploration. But these are viewed by the OECD and International Energy Agency as a form of governmental financial support for fossil fuels. It would be better if such support was focused on promoting the development of low-carbon sources of energy,” she adds. Angel Gurría, secretary general of the OECD, has echoed this statement, warning countries against establishing a long term reliance on shale and other new fossil fuels. In a report released late last year, the OECD implored governments to “take a hard look at policy measures that subsidise or encourage the exploration, production and consumption of fossil fuels” and “eliminate” any policies that conflict with cost-effective carbon prices.

Undoubtedly, there are still a number of challenges associated with both fracking and the wider shale gas industry. There have been suggestions that the industry could generate up to 64,000 new jobs and create a £33bn worth of investment opportunity in the UK over the next 18 years. However, figures such as these should be met with a degree of caution. The UK’s shale sector is at an embryonic stage, with companies still vying for drilling licences and ongoing uncertainty surrounding the amount of shale present. Companies looking to invest in the space should be wary. Although the government has promised to simplify the drilling process, there are still a number of issues relating to planning permission which are yet to be ironed out. Equally, issues such as public perception and geological concerns are major hurdles, even before factoring in the results of any exploratory drilling. Managing relationships with local communities will be pivotal to the future prosperity of the shale gas industry in the UK.

Right now, large portions of shale gas located in the north of England are unrecoverable. If means can be found to safely and economically extract this gas, it would clearly have an enormous impact on the country’s gas production capabilities and would help to safeguard the UK’s energy security going forward. While the country’s reliance on imported oil and gas may not be broken by a shale revolution, it would at least serve to diversify the UK’s energy supply base.

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Richard Summerfield