Fuel Pricing Policy & Notional Subsidy

Last January the Finance Ministry announced that they wanted to reduce the Rs 18000 crore subsidy bill by moving to export parity price for diesel.

Every time there is a price rise in petroleum products there are more or less similar reactions from people, media, and economists of our country. For many of us the subsidy word is taboo. When we ask private citizens (who are either economist or intellectuals or just ordinary folks on twitter) all that we hear is that subsidy is bad and government should reduce it as soon as possible.

We have been repeatedly told that the government doles out so many thousands of crores in the form of subsidies on different petroleum products.

However while discussing the details of such subsidies scant attention is paid to the net contribution from petroleum sector to government exchequer. Also brushed over is the reason for government’s interference in petroleum pricing even 10 years after allegedly moving away from the APM (administered price method)

Following is quick summary of net contribution government of India received from petroleum sector:

Table 1: Net contribution to Government exchequer

Net contribution to government exchequer has always been positive, except for the years 2008-09 and 2011-12. However it would be unfair to club all the petroleum products under one bracket. The government subsidies cover only certain products such as petrol, diesel, LPG and Kerosene.

                                           Figures in Cr

Table 2: Under recovery by marketing company

So while on on hand the government claims to heavily subsidize petroleum products how does one explain a net positive contribution to the exchequer from the very same petroleum products?

To understand this it is necessary to first understand how petroleum products are priced both in India and in the world at large.This is where we have to understand how petroleum products are priced in India and in world at large.

Oil and its importance are unquestionable. Americans have been accused of waging war to secure oil reserves and Arabs have been accused of becoming slum dog millionaires. Oil production and consumption have caused both sorrow and happiness for the economist (and government servants who manage policy decisions).

Countries have followed varying fuel pricing formulas based on various factors such as size of the country, geographical location, weather, per capita income, industrial requirement, import/export requirements, balance of payment issues and so on.

As far as the Indian pricing model is concerned  the objectives of government intervention and pricing control were clearly enunciated by an expert committee under the Chairmanship of Kirit  S Parikh back in 2010:

1. To protect poor consumers so that they may afford kerosene for lighting
   

2. To provide merit goods to consumers such as clean cooking fuels like natural gas, LPG and kerosene to replace use of biomass-based fuels such as firewood and dung.
   

3. Another reason is to insulate the domestic economy from the volatility of the petroleum prices on the world market. It is feared that complete pass through of increase in world oil prices may cause inflation which may persist even when oil prices come down.
   

4. However major objective of the policy is to have efficient and competitive oil economy that promotes efficient use by consumers, appropriate choice of fuels among substitutes and a proper choice of technique.
   

It is interesting to note that Kirit Parikh was also instrumental in drafting the Integrated Energy policy in 2006 where he discussed different methodologies used in petroleum product pricing. They include:

• Import Parity price
  
• Export Parity price
  
• Trade Parity price
  

Determination of petroleum price has never been an easy subject world over. Different countries have tried variants of above methods at different periods and have evolved their pricing policy based on their own context.

In the case of India too the government has tried different methodologies  The below is a chronology of petroleum products pricing methodologies that have been applied in India: 

• Pre-1975 : Import Parity Pricing (IPP) in pre-1975 era (Damle; Talukdar; and Shantilal Committees)

• Post-1974/75: Oil Prices Committee (OPC, Krishnaswamy, 1974) – cost plus basis (also called administered price mechanism or APM): crude oil cost + refining cost + 15 % return on capital employed (RoCE)

• 1984: Oil Cost Review Committee (OCRC, Iyer, 1984) – revised the RoCE element to weighted average of (a) cost of borrowing and (b) 12 % post-tax return on net worth. Oil Pool Accounts maintained by Oil Co-ordination Committee (OCC): Crude Oil Price Equalisation (COPE) Account, Cost and Freight (C&F) Account, Product Price Adjustment (PPA) Account

• 1998: Dismantling of APM, closure of oil pool Market Determined Pricing Mechanism (MDPM) – From April 1, 1998, moved to adjusted import parity pricing for controlled (MS, HSD, SKO, ATF, LPG) products. Prices / markets decontrolled for industrial products (Naphtha, FO, LSHS, Bitumen, Paraffin)

• 2002: MS and HSD deregulated in 2002

• 2006: Trade Parity Pricing (TPP, Rangarajan, 2006) for MS and HSD (with weight of 80 % IPP and 20 % Export Parity Price (EPP))

• 2010:  Continue with TPP (Parikh Committee, 2010) for HSD, market determined pricing for MS – Government takes an in-principle decision to move to market determined pricing both at refinery gate and retail level for HSD at an appropriate time

• Recently Finance ministry has proposed to use Export Parity Price.

Above information is compiled by M. Mukesh Anand in the paper : Diesel Pricing in India: Entangled in policy maze for National Institute of Public Finance and policy.

It is important to note observation made by Mr Kirit Parekh on setting up petroleum prices

“If prices are to be fixed by the government, it has to be based on some principle. Prices can be fixed based on pre-determined formula, which is derived from principles like import parity (IPP), trade parity (TPP), or export parity (EPP). This approach is also fraught with major deficiencies.

The formula often involves elements of cost-plus. In an industry, which is continuously changing, a prescriptive and biased cost-plus pricing formula requires continuous monitoring and periodic adjustments in certain components of the formula. For instance, there is no single or unique formula for import parity which is applied globally”

Although India has been a importer of crude oil sustained capacity addition in refining has allowed it to be a net exporter of petroleum products. Coming back to price determination methods lets us go through some quick definitions and also look at the issues associated with each pricing method

Import Parity Price: Import parity pricing (IPP) is the policy of pricing locally refined petrol on the basis of the cost of importing refined petrol. IPP is simply the landed cost of obtaining refined product from overseas refiners. When evaluating pricing, it is important to note that prices at all stages of the petrol supply chain are heavily influenced by the landed price of imported petrol into India, whether or not the petrol sold is actually refined in India or imported. The IPP based formula can be expressed as follows

IPP Based price = benchmark price + quality premium + shipping cost + wharfage + Insurance & Loss + Custom duty. (Benchmark price is taken at Arab Gulf.)

Impact of IPP based formula pricing

Use of IPP based formula pricing has downstream impact for petroleum product pricing all the way in supply chain. As highlighted before India is net exporter of the petroleum products, IPP formula is dependent on the buy-sell arrangements entered into between oil marketing companies and refineries/importer.

Although most of the PSU oil marketing firms have their own refinery, they still buy from each other in individual states based on the own refinery capacity and market demand. Such buy-sell arrangements are generally on bilateral basis and period of contract sometimes are anything between 6 months to 12 months.

Just to give you example, Reliance and Essar have stopped selling petroleum products out of their petrol pumps but they continue to supply government agencies. One fifth of diesel sold through IOCL, HPCL, and BPCL is supplied by Reliance and Essar

A key implication of such buy-sell arrangement is that such arrangements(which in turn impact IPP) are based on notional cost of imported product instead of actual cost of refined product from domestic refinery.

Refiners do not pay Arab Gulf benchmark price or incur cost associated to quality premium, ocean freight, insurance, or any such associated cost, but all these components are paid on actual basis, based on the long term buy-sell contract between refineries/oil producing companies and oil marketing companies.

Issues with the IPP are 1) the domestic refiner has little motivation to operate unless they get the right  import price 2) buyers may not pay more for local production than imported one (which will be the case if crude is bought at IPP prices) 3) This leaves imported refined products as the only alternative and there are no constraints on availability.

Till 2006 the government continued to use Import Parity Price formula pricing, however post Dr C Rangarajan committee report the government has adopted trade parity price formula with 80% weight to Import and 20% to Export.

While recommending trade parity principle committee has also made following observation

The government  effectively adopted trade parity price from 2006. The subsidy bill stood at 49,387 crores with the crude oil price at 62.46, and at year ending 2011-2012 has gone up to 1,38,541 crores. Consumption stood at 1,31,668 BBL in 2006/7 and 1,63,494 BBL (oil barrel)

Export Parity Price: Export parity pricing (EPP) is the policy of pricing refined petrol on the basis of the value of product sold at a specific location in a foreign country ( but valued from specific location of the exporting country). EPP is simply the CIF (Cost Insurance and freight) value of refined product from overseas refiners minus freight and insurance cost. EPP based formula can be expressed as follows

EPP based price = benchmark CIF price – freight – insurance

* I am yet to look at the finance ministry export parity price calculation circular. Above calculation is generic concept

Diesel Pricing

If you think that increased diesel prices to end customers like you and me would decrease the subsidy load, let’s look at how much tax you and me pay and how much under recovery oil marketing companies incur.

The Finance ministry wants to reduce diesel subsidy by 18,000 Cr by applying export parity price on diesel. Increasing retail selling price is a bottom up measure to reduce under-recovery and opting for export parity price is top down measure to reduce under recovery to oil marketing companies .

Under recovery to oil marketing company is calculated as difference between dealers price at depot minus trade parity price/Import Parity price/Export Parity Price as the case may be.

In the argument against export parity price, like import price parity price, EPP is assumed cost to refiners or oil marketing company. This is not actual cost of production to refiners or to the oil marketing company. Besides net contribution from one Litre of diesel to government is still 1.64. That’s what I call Notional Subsidy, we can very well see that subsidy (Under recovery to OMC) of Rs 8.65 on diesels is not really subsidy.

If government really wants to put fewer burdens on common man, it can very well remove all taxes on diesel and still have net contribution to its exchequer. But it does not do that – perhaps because it impacts their tax to GDP ratio negatively.

Of-course out of Rs 10.29, Rs 5.6 is towards VAT, which is part of the states tax exchequer. VAT in essence is sales tax as there is input credit allowed for custom duty paid, which in a way impacts gross refinery margin. The proposed GST legislation might still leave out petroleum out of its purview

The government is not in the same situation as far as SKO (PDS kerosene) is concerned. Let me quote Report of expert group under chairmanship of Mr Kirit Parekh in 2010

“The primary objective of subsidizing kerosene is for lighting purpose. In the absence of electricity, kerosene has, for long, been the only source of lighting (apart from more expensive vegetable oil-based lamps).”

“Since kerosene subsidy is going largely for lighting, the allocations should be reduced as more and more BPL households are connected to the electricity grid. Such connections under the RGGVY are subsidized and continuing kerosene supply to such household’s amounts to double subsidy.”

“Only 1.3% of rural households use kerosene for cooking. Among the poorest four deciles, less than 1% used it for cooking but 60% used it for lighting. As BPLhouseholds meanwhile are connected to electricity grid under Rajiv Gandhi Gramin Vidyutikaran Yojna (RGGVY), the percentage of BPL households using kerosene for lighting would have been reduced substantially by now” (This data was collected in NSSO survey 2004-05)

Apart from highlighting issue of double subsidy, it is important to note PDS kerosene is mainly for lighting purpose. This ideally should have been addressed with appropriate policy statement and implementation of the same in power ministry.

There is an additional catch, “distribution of PDS kerosene has developed an inverse relationship with the income levels of states, which needs to be rationalized. For instance, the average per capita kerosene allocation in high income States in 2007-08 was 14.1 litres which was 41% higher than that of the low income States.”

We have spent Rs 1,53,275 Cr since 2004-05 on subsidizing PDS kerosene, which apparently is used not for cooking but for lightning purpose. I wonder how many power plants could have started with this money. (Power policy is different topic may be my next blog!).

In an ideal world the government should build more power plants which in turn should reduce consumption of kerosene. On the LPG front we have seen government’s effort to cap  number of LPG cylinders customers can use and all the associated drama with it.

Kirit Parekh in his report did mentioned that any effort to ration or limit number of cylinders at subsidized price without “smart cards” will indirectly promote inspector raj rather than effectively reducing subsidy. This is a text book example of a perverse implementation of a decent recommendation.

To summarize for easier reading:

• Net contribution from petroleum products to government to exchequer has generally been positive except for year 2011-12 and 2008-09

• India might be a crude oil importing country, but it is a petroleum product exporter.

• Import parity price or trade parity price is not really suitable for India because it increases notional cost for price calculation base.

• Three main contributors to government subsidy bill are diesel, kerosene and LPG.
  

• It is important to understand the differences between import price parity, export price parity and trade parity price.
  

• Government earns Rs 1.64/litre for diesel and yet claims to reduce subsidy by increasing retail selling price of the same.
  

• 60% of kerosene usage is for lighting purpose by poor families.
  

• There is good number of cases of smuggling of kerosene across border and there has been reported case of adulteration of diesel with kerosene.