Oil Subsidies in India – Need for reform?

Existing in an age of rapid technological advancement, mankind’s dependence on modern comforts has become inevitable. While people are constantly trying to improve their quality of life, there occur many crossroads where only one choice can be pursued at the cost of giving up another. And the world today has made one such choice – to use very scarce fuel resources to satisfy needs of the present generations; giving little importance to their judicious utilization.

It is a well known fact that fuel resources such as petrol and diesel are exhaustible and will soon run out in the next few decades. Yet, governments of most developing countries have chosen to allow for import of these resources to facilitate the process of economic development. This has been made possible by the provision of large amounts of subsidies that to oil producing and marketing corporations.

ImageIndia has historically subsidized fuel prices to prevent the economy from the shocks of price volatility in the international market. On a more ambitious note, the government did not want to deprive its citizens of access to fuel. Or perhaps, the real motive was to sustain its recognition as a strong contender in the development process at the international level, when pitted against its close counterparts.

The price of petrol has risen from INE 33.45 per liter in 2002 to 78.57 a liter in 2012. In a span of a decade, there has been a more than double increase. While this has far-reaching consequences, it is important to analyse the reasons that may have contributed to this phenomenon.

Until 2010, the Government of India controlled the prices of petrol under a system called ‘Administered Pricing Mechanism (APM). In June 2010, the government deregulated the price of petrol. In India, petroleum is one of the most subsidized sectors. The government provides fiscal subsidies as well as cash assistance to Oil Marketing Companies (OMCs).

The dynamics of petrol pricing mechanism in India has many loopholes that have added burden to the consumers. Firstly, the price of petrol is determined by that set by oil companies in Singapore. Adding charges of freight to that price, the rupee-dollar exchange rate is applied to arrive at the price to be sold in Indian market. But the startling fact is that India does not import any petrol from Singapore! Secondly, the price of petrol has no relevance to its cost. Thirdly, the fluctuations in day-to-day or hour-to-hour currency exchange rate in the international market have a huge impact on the nature of returns of OMCs.

It is interesting to note that Indian imports only crude oil and not petrol or diesel itself. Ideally, petrol ought to be priced based on the cost of import of import of crude oil, cost of refining into petrol and additional transport and marketing costs. Another point of curious interest is that most upward revisions of oil prices in India have coincided with downward price spiral in the international markets!

ImageThe flawed pricing mechanism has adverse impacts on the OMCs. They are as follows.

1)      There is no scope for competitive pricing in the existing framework. Any increase or decrease of petrol prices has to be uniform across all 3 market players – IOC, BPCL, HPCL.

2)      There has been steady growth in ‘under-recoveries’ – the difference between cost price of petrol and regulated price at which it is sold, after accounting for subsidy provided by the government. The total size of the under-recoveries in 2011 was INR 78,190 crores – a mammoth 1.07% of our GDP!

3)      There is increasing debt burden as most of the under-recoveries are overcome by borrowings. This reduces scope for process development or expansion in the future.

4)      Declining government revenues has caused the government to reduce subsidies and cash transfers, therby increasing the losses faced by OMCs.

The government is faced with an outstanding subsidy bill of Rs 8,00,000 crore to OMCs over the next 5 years. The government has undertaken a slew of measures to curb consumption in order to reduce this figure. In this context, the debate about need and nature of government subsidies has created a storm. About half of the price paid by consumers per unit of petrol goes to the government in the form of taxes. Some economists believe that if this amount was kept to the minimum, the volume demanded would increase and result in greater sales. This would reduce the dependence of OMCs on subsidies. But the most logical solution seems to be to realign the pricing process in line with that of the international market. This would eliminate the impact of foreign exchange market fluctuations on profits of OMCs.

But a more appropriate questions would be – are fuel subsidies helping the citizens of India at large?

To answer that question, let me consider the following aspect of the impact of fuel subsidies.

1)      It has resulted in mounting fiscal deficit. The subsidies and government share of under-recoveries has been denting the treasury. It will be sensible to continue providing such subsidies only if revenues generated by the oil industry in the form of tax surpasses this amount.

2)      The total amount of subsidies provided to the oil industry is much more than that spent by the government on the social sector – to improve health and education. What must be considered here is the opportunity cost of improving living conditions of the people.

3)      While more than a quarter of Indian population lives below the poverty line with no access to fuel or electricity, a massive amount of money is spent to appease the needs of a relatively small section of the society – the upper middle and high class that own automobiles and use electricity to a large extent.

4)      There is a growing threat of reduced interest in investment in cleaner energy sources. Subsidized fuels can increase consumption that has immense detrimental impact on the environment.

The decisions related to pricing and subsidies of the oil industry have close political ties. It has been observed that during the NDA regime, there were small rises in petrol prices over a large span of time. In the UPA regime, however, the jumps have been sudden and massive, burning a big hole in the pocket of consumers! Successive mismanagement of this sector and absence of reforms have resulted in disadvantaging the people.

The only way ahead is a three-pronged approach.

1)      Change in price mechanism to allow domestic prices to be in sync with that of the international markets

2)      Abolition of government price control

3)      Systematic dismantling of government subsidy programs

The positive impact of such an action plan is wide in scope. It would make more public funds available for development purpose. It will make OMCs more competitive and efficient and enhance their capacity to grow and expand. Over all, the entire economy is put on a path of steady energy-driven progress steered towards the right direction.

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3 comments on “Oil Subsidies in India – Need for reform?

  1. Thomas Arun says:

    Wav….liked your article..
    You have forgotten to mention about the taxation that is imposed on petroleum products. Almost all the state govt impose a state VAT of 25%(average) and there is also central govt tax. Together they are getting a huge income and only a miniscule of it is being paid out as subsidy.

    So it makes sense to free up the pricing mechanism and to decrease the tax rates that are imposed on the petroleum products

  2. Interesting view. But will the oil subsidy reform in any way change India’s position as a net importer of oil is the big question?

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