The conservative government’s decision to tax energy trusts will significantly damage an important component of Canada’s energy industry. The tax will kill jobs, push down energy production and, ironically, probably reduce government revenue.

Energy trusts are forecast to make cash distributions totalling $5.7 billion this year. And if the new 31.5% distribution tax were implemented immediately, it would haul in $1.8 billion — far more than the combined $1-billion “tax leakage” federal Finance Minister Jim Flaherty estimates for Canada’s entire income trust sector. But surely that latter figure is absurd. More likely, the Finance Department’s modelling predicts a plunge in cash distributions, requiring the steep rate to bring in a more modest amount of taxes.

So, why would cash distributions plunge? Largely because Canada’s 35-odd energy trusts produce oil and natural gas from aging, declining, higher cost/lower return fields. They’re our producers of last resort. The trusts use their low-cost capital and tax-free income to make money, squeezing the last oil and natural gas out of these old beaters.

John Brussa, the corporate lawyer credited with co-inventing energy trusts, describes them as “sorters of capital” playing a complementary industry role. Buying these old assets from big international companies allows the majors to focus on driving Canada’s main energy growth play, the oilsands. Similar deals with conventional explorers unlocks capital to drill for new pools.

Losing the tax advantage will have a cascading effect. Combining new barriers to accessing capital, rising cost of capital and taxes on all income will drive down real returns on the higher-cost, energy-producing assets. They’ll be shut down, decommissioned and abandoned. Nobody knows how much of the trusts’ combined one million barrels of daily oil- and gas-equivalent production will become uneconomical, but even 20% would mean losing 200,000 barrels a day. That’s $3 billion in evaporated cash flow a year, and hundreds of millions of barrels of oil and natural gas left in the ground. In an energy-starved world, that doesn’t seem to be in Canada’s interest.

Ironically, energy trusts have always generated taxes — just not corporate income taxes. They pay local property taxes on their facilities, provincial royalties on production (15%-25% off the top line), GST on their purchases, personal income taxes on their employees’ wages, capital gains taxes when they became trusts, and personal income taxes on their distributions to non-RRSP accounts. And the depletion allowance allotted to produced reserves is first distributed to unitholders as “return of capital” and is taxed upon divestment. As the trusts shut down their uneconomical volumes, revenue from all these sources will dry up.

Alberta Premier Ralph Klein has praised Flaherty’s tax move, claiming Alberta had been “losing” hundreds of millions of tax dollars. Klein should be the last to complain. Alberta is the primary recipient of energy royalties. As the new tax drives down production, Alberta’s royalty take will fall. Flaherty’s tax move will effectively transfer money from Alberta to Ottawa. In fixating on a trickle of leaking provincial corporate income taxes while ignoring the big picture, Alberta got seriously played.

Few bureaucrats understand energy trusts’ benefits. Too bad. Flaherty could have found a way to ease them toward partial tax exposure while preserving their benefits. Instead, he has used a cannon to crush a canary. IE