Israel’s Natural Gas Debate Missed the Point Entirely, Economist Says

Economist Ady Pauzner says most of the benefits of the gas will remain with the public no matter what the price, which we should worry might be too low.

Offshore Leviathan natural gas drilling site.

The controversy over the government’s plan for developing Israel’s offshore natural gas has created an odd precedent, says Ady Pauzner, a Tel Aviv University economist. “People on the economic left are fighting to have the money go to the public, while people on the economic right are fighting to have the money go into the government’s pocket.”

Thus Prof. Pauzner says the two sides are fighting over the wrong issue; ultimately the price of natural gas in Israel isn’t very important. But price changes will alter the distribution of gas profits between “the public and the government or between Tshuva and the industrialists and other capitalists,” says Pauzner.

Yitzhak Tshuva is the controlling shareholder in the Delek Group, which with U.S.-based Noble Energy controls Leviathan and Tamar, Israel’s two largest offshore gas reserves. “It’s not true that it involves a battle over the division of profits between the public and Tshuva,” Pauzner says.

Pauzner made his comments in a study for the Aaron Institute for Economic Policy at the Interdisciplinary Center Herzliya. He did the study with Dr. Yehoshua Hoffer on the Zemach committee’s conclusions on gas-export policy.

The analysis was published at the beginning of the year before the government and the two energy companies clinched their gas framework deal, but the analysis remains true.

The analysis involves several basic principles. The first is that the gas must be exported because the export price (less the costs directly involved in exporting) represents the true price of gas to the Israeli economy.

Unlike the tens of thousands of demonstrators who protest every Saturday night against the “gas theft” and “inflated prices,” Pauzner is actually worried that Israelis will pay too little for their gas. That would lead to inefficient consumption, he says. Exports act as an alternative to domestic sales and ensure that the domestic price is optimum.

But Pauzner warns that exports will be sold at too low a price. A low export price might be in the interest of the energy companies but not for the Israeli economy. And declining export prices in Europe are bringing Israel closer to that prospect, he adds.

Second, since the optimum price of gas is derived from the export price, any regulatory agency that intervenes in the price or export level is distorting the market. Pauzner warns of these distortions in his paper, first and foremost the regulatory impact of the Sheshinski committee rules on gas and oil taxes.

The committee didn’t call for intervention in gas pricing (which instead was addressed by the gas framework). In practice, the tax rules proposed by the panel and made into law set the price because they effectively determine profit levels in the gas business.

Public profits the most

The Sheshinski committee rules require the gas field partners, notably Delek and Noble Energy, to pay 12.5% royalties on the first dollar of sales, a 25% corporate tax after recouping costs, and a windfall profit tax.

When the gas fields are running at capacity and the windfall tax is fully in effect, 70 cents on every dollar of profit will go to the government in either royalties or taxes; that is, it will go into the public’s pocket. If you take into account that the public owns shares in Delek, the real split is 80 cents for the Israeli public and 20% for Tshuva and Noble’s shareholders.

But with gas consumption, the situation is very different from what the public perceives. Government and households (the latter indirectly via gas-generated electricity they use) account for just 40% of all gas consumed. The rest is used by industry.

But even in the case of industry, most of the savings from gas reverts back to the consumer in the form of lower prices for goods and services, while at least a quarter is recouped through corporate tax.

This means the public dominates both sides of the gas equation. On the seller’s side it accounts for 70% to 80% and the gas companies the rest. On the consumption side it accounts for 80% of the benefits and business the rest. Every additional dollar to the gas price therefore is a dollar that comes almost entirely from the public and goes back to the public.

Basically, the nub of the controversy is how much of the gas profits should go to the government and how much directly to the public by scrapping the gas framework and lowering the price of gas. On this point, there has been an interesting divergence of opinion, with people on the left effectively calling for lower prices and tax revenues for the government.

People on the right support the gas framework and the tax plan laid out by the Sheshinski committee, which means more profits remaining with the government. In both cases, Delek and Noble’s share of the profits is substantially smaller than what the public gets.

“The allocation of gas taxes means ‘either us or the government,’ not ‘either us or Tshuva,’ so the gas price won’t be such a dramatic issue,” Pauzner says.

“Important is that the price of gas be right for the economy, meaning based on the economic price of exports. Maximizing the overall value of the gas is much more important than the division of profits.”

Reservations about tax rates

Pauzner does have reservations about how the Sheshinski tax rates were set. The 70% tax rate on gas profits only works when the Sheshinski rules are fully applied. Until that happens, the Sheshinski rates give concessions to the gas producers by recognizing their costs in the price, a formula also known as the R factor.

The Sheshinski committee said costs should be recognized only after the companies have recovered their total costs plus 50%. And the costs continue to be recognized, albeit it at lower level, until the companies recover 230% of their costs. This means that until the gas companies take in profits double their investment, Sheshinski’s windfall profit tax won’t kick in, though the companies will pay royalties and ordinary corporate tax.

On this point, the gas framework intervened in the Sheshinski formula by boosting the recognition of expenses by about $1.5 billion. All told, it's estimated that the gas partners will have earned between $9 billion and $12 billion before the windfall profit tax applies.

Pauzner believes the Sheshinski committee was too generous in setting the cost level, and the gas framework makes it more generous still. In exchange for such generosity, Israel should have raised the gas partners’ tax rate to about 75%, he says.

Since profits on the gas, even from Tamar alone, will probably be much more than $12 billion, the gas partners won’t be able to skirt the windfall profit tax. But along the way, they will earn several billion dollars at much lower tax rates.

Did Israel make a mistake regarding the recognition of expenses? At least regarding that extra $1.5 billion, a number of people in government think so.

But the disagreement was forgotten in the broader ruckus of the framework debate. Critics said supporters of the plan were corrupt and served the tycoons’ interests, while opponents were overblown populists.

The plan isn’t a total mistake, but that doesn’t mean everything is right. The aggressive public debate ruined the chance for a nuanced diagnosis, and that’s a shame.