If the art of taxation consists of plucking the goose in a way that yields the most feathers with the least hissing, the windfall profits that European energy firms enjoyed after Russia invaded Ukraine were surely an invitation to tax to the hilt.

On grounds of fairness, who could possibly complain? Well, not so fast. As Germany has shown, it’s a little bit more complicated than that.

The surge in prices for gas, electricity and various commodities triggered by the conflict has confronted governments across Europe with severe economic challenges. Germany was highly dependent on Russian gas imports when the war broke out, so it was particularly affected by the jump in energy prices. The cost of heating a home or operating energy-intensive industries such as steel, chemicals, glass and cement became almost prohibitive. At the same time, numerous energy companies were reaping extraordinary profits.

Against this background, the German government's desire to tax some of the windfall profits to help pay for the support it was giving consumers, notably through a “brake“ on energy tariffs, was politically understandable. But the economics is not so straightforward. The excess profits can be traced back to Vladimir Putin’s adventurism, but they are also the result of an efficient and properly functioning market mechanism.

Lawmakers thus had to be careful not to destroy trust in this system when considering the level of an excess-earnings tax. Pitched too high, the surtax would have done more harm than good in the medium and long term. The proverbial goose would have hissed and honked its head off.

The graphic below illustrates how the market price for electricity (day ahead) is set by the marginal cost of the most expensive electricity-producing power plant. Since this is usually a gas-powered facility, the leap in gas prices as a result of the war in Ukraine led directly to higher electricity prices. Because of this uniform market price, plants generating power using other technologies (e.g. wind/PV, nuclear power, lignite and hard coal) and enjoying lower marginal costs were able to realise extraordinary profits (so-called "inframarginal profits“).

Illustrative representation of price formation in the liberalised electricity market.

A key challenge for regulators and policymakers is to determine at what level these profits represent an excess return. Essentially, the existence of high profits in the electricity market during certain hours is vital to enable power plant operators to cover the cost of investing in new generation capacity. In light of the need for enormous investments in the energy transition to Net Zero, policymakers cannot afford to give the impression that "normal" profits could be severely restricted in the future. Striking the right fairness/incentives balance is crucial.

Germany introduced its tax on windfall profits in the energy sector on 1 March 2023, based on EU guidelines and varying depending on the specific technology. Importantly, only 90% of the windfall profits were taxable in order not to distort existing market incentives for the companies in question.

In light of a subsequent sharp decline in energy prices, the Ministry for Economic Affairs and Climate Protection decided on 9 June 2023 to halt the windfall tax levy at the end of the month. In doing so the ministry was sending an important signal that the decision to tax excess profits was a one-time measure necessitated by extraordinary events and was not meant to undermine market forces.