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Biting the fuel subsidies bullet

A new set of studies make a convincing argument for reducing fossil fuel subsidies, writes Darryl D'Monte, and demolishes the claim that raising diesel prices will impact the poor most and send inflation spiralling

Reducing diesel subsidies

It was the best of times and it is the worst of times as far as subsidies on fossil fuels in this country are concerned. Policymakers were all set to raise the price of diesel (for political correctness it is euphemistically called "reducing diesel subsidies"). The analysis was done by a committee headed by Dr Kirit Parikh who in 2010 was in the Planning Commission. Only last month, the media announced that "the government is preparing to bite the bullet, with partial decontrol of diesel prices after the presidential election on July 9. Prime Minister Manmohan Singh, also handling the finance portfolio, is considering a slew of measures to trim the huge fiscal and current account deficits," (Business Standard, July 6).

What nobody in power foresaw, but ought to have since the writing was on the wall, was the emerging drought. The meteorological men, who resort to obfuscation at the best of times, turned ostrich-like; agriculture minister Sharad Pawar took his cue from them, referring for several weeks to the "drought-like" conditions. This sent all thought of reform for a toss, with the states, led by Punjab and Haryana (the major grain-growers) asking for nothing less than a 50% subsidy on diesel. The finance ministry had to dig into its coffers and come up with a few hundred crores to subsidise the price of diesel in drought-affected states, in anticipation that farmers would hike pump usage to irrigate their parched fields.

By sheer coincidence, August 20 marks the release of the most exhaustive studies conducted on the state of fossil fuel subsidies and measures to reduce them in this country. They were commissioned by the Geneva-based Global Subsidies Initiative (www.iisd.org/gsi), whose parent body is the International Institute for Sustainable Development in Canada. GSI's broad agenda is to make all subsidies -- good and bad -- transparent. One well-researched study was conducted by the National Institute of Public Finance and Policy (NIPFP), whose paper is entitled 'Diesel Pricing in India: Entangled in a Policy Maze'. The study of the other (also-Delhi-based) institution, The Energy and Resources Institute (TERI), is titled 'Fossil-Fuel Subsidy Reform in India: Cash Transfers for PDS Kerosene and Domestic LPG'.

Typically, the NIPFP, while coming up with all the facts and figures relating to this admittedly complex issue (hence its own reference to a "maze"), was hesitant, being a semi-official body, to conclude with any hard-hitting recommendations. These have now been fleshed out by two GSI staffers who have come up with pointed policy prescriptions for reform of this sector, all gleaned from the studies. They have also, helpfully, compressed the complicated statistics and labyrinthine policy changes into a crisp summary for journalists.

The use of fossil fuels or petroleum products engages the attention of every Indian, even granting that some 600 million -- half the population -- cannot afford to buy any form of commercial energy (firewood, coal or any type of petroleum-based energy) and 400 million have to make do without electricity.

There is a great deal of confusion over fossil fuel subsidies in this country. Most motorists will be surprised to learn that although the price of petrol is now partly decontrolled, it is still subsidised. Diesel of course is supported very much more, as is kerosene which is the poor man's (rural and urban) lighting and cooking fuel. Even the middle class, which relies on liquefied petroleum gas (LPG) to cook with, pays far less than its actual cost.

The policy prescriptions begin with the sobering facts: "In fiscal year 2010-2011, the Government of India spent Rs 43,904 crore ($ 9.6 billion) subsidising retail prices of diesel, kerosene, LPG and, to a lesser extent, gasoline. In addition, oil companies incurred Rs 37,190 crore ($ 8.2 billion) worth of under-recoveries, of which Rs 30,297 crore ($ 6.6 billion) was provided by upstream national oil companies."

Newspapers report that the new (or 're-newed') finance minister, P Chidambaram is unhappy with the handling of the 'subsidy regime' by his predecessor. The recommendations of a committee headed by former finance secretary Vijay Kelkar will be taken into account while making changes in the projected subsidy outgo. The petroleum subsidy, according to a senior finance ministry official, has been estimated in the 2012-13 budget at Rs 43,580 crore, compared to Rs 64,481 crore in 2011-12. Interestingly enough, the corresponding figures for food subsidy are Rs 75,000 crore this fiscal versus Rs 72,823 crore the previous year. The difference in the two figures, between the food and petroleum subsidy for 2011-12, is only Rs 8,342 crore.

In 2010-11, as we have seen above, the total petroleum product subsidy and oil marketing companies' (OMCs) under-recoveries amounted to an even greater figure -- Rs 81,094 crore. That year, according to Food and Public Distribution Minister K V Thomas (http://www.financialexpress.com/news/food-subsidy-bill-hit-r45-125-cr-on-december-15-says-thomas/889687/), the food subsidy was far less -- Rs 62,989 crore, a difference of Rs 18,105 crore.

In this context, it would be a revealing socio-economic exercise if we were to find out who in the upper echelons of diesel-guzzlers -- not owners of trucks or diesel-operated machines etc -- uses diesel for what; not least, owners of Mercedes and other top models of cars, all run on highly subsidised fuel. This would include a great many who cry themselves hoarse about the "give-aways" on food for the poor, causing a tremendous drain on the public exchequer (often translated as "our taxpayers' money").

In the document released August 20, author Mukesh Kumar Anand of the NIPFP cites how diesel accounts for 38% of consumption of all petroleum products. His paper goes on to say: "It is used as an input in activities that together account for almost 40% of gross domestic product (GDP). But, almost 65% of diesel is used in transportation activities that contribute to 6.6% of GDP. Road-transportation services constitute more than 70% of GDP from transport services (emphasis added). Diesel sold from retail outlets located along national and state highways constitute more than three-fifths of all retail sales.

"Operation of trucks uses more than one-half of diesel consumption for transportation. Although railways consume around one-fourth as much diesel per net tonne-kilometre as trucks, the ratio of rail to road in passenger traffic stood at 15:85, and in freight traffic at 30:70. Glacial (ie, painfully gradual) change in railway infrastructure is likely to push the increase in freight on to roads and the share of road transport may rise to 85% (from 70%). Unless road infrastructure is improved, average speed of road transit may decline and worsen aggregate diesel-use efficiency." Anand's table below puts it in a nutshell:

Sector-wise share of GDP and total diesel consumed (%)

Sector

Mode

Diesel consumed

GDP

2008-9

2009-10

2010-11

2008-9

2009-10

Transportation

Railways

4.2

4.0

4.0

1.0

1.0

Water

1.4

1.2

0.9

5.6

5.5

Aviation

Negligible

Road

59.6

60.0

60.4

Industry

10.2

10.7

10.5

15.8 (10.6)

15.9 (10.7)

Power generation

8.3

8.3

8.2

2.0

2.0

Agriculture

11.9

12.1

12.2

15.7 (13.3)

14.6 (12.3)

Miscellaneous

4.2

3.5

3.6

   

Source: GDP data from http://mospi.nic.in

Note: GDP data in transportation services is available for 'railways' and 'other transport services' the latter including air and water transport; share of industry in GDP pertains to 'manufacturing' (registered [in parenthesis] plus unregistered); share of power in GDP relates to electricity, gas

Another, less well appreciated outcome of raising diesel prices is that people will go in for more energy-efficient cars, thereby reducing the air pollution that now bedevils every town and city in this country. The high cost of "dirty diesel", as the Centre for Science and Environment castigates it, is not generally known. The Society of Indian Automobile Manufacturers claims that India is using low-sulphur diesel, and that the fuel is widely used in Europe, among other regions. But the fuel actually used in the EU is the ultra-low sulphur variant. In this country, the tiny diesel particulates generated by vehicles and other sources lodge in the chest and can cause cancer, apart from respiratory problems. Virtually every urban Indian suffers from this form of pollution at one time or another, given the overwhelming use of diesel in both private and public transport. From the NIPFP study, GSI points out that by merely raising diesel prices by Re 1 a month per litre over a year, under-recoveries in the petroleum industry will be reduced.

As far as LPG is concerned, used by the middle and upper middle classes, reform should begin with a small increase in cylinder price this year itself. It should move into capping the use of subsidised cylinders at eight per household per year, which will certainly make households that much more energy-conscious. In time, all subsidies on LPG should be removed, though that will also affect the relatively poor who visit small roadside eateries and the like for their daily meals; these outfits almost invariably cook on LPG.

The study by TERI marks a big break with traditional practice when it comes to kerosene. The overall subsidy should be replaced with a targeted, unconditional cash transfer to poor households. This is where the Aadhar unique identity (UID) scheme being implemented by Nandan Nilekani and his team (and often resisted by bureaucrats and politicians in other ministries who feel he is treading on their turf: a rapprochement has now been worked out) comes into play. The policy prescriptions recommend "redistributing 80% of the kerosene subsidy and under-recovery to all below the poverty level (BPL) households could provide a direct transfer of Rs 200 per month; payments should be linked to inflation rates".

Total cost of India's fuel subsidies in 2010-11

Fuel

Desired price*

Realised price*

Fiscal subsidy

Under-recovery

Total subsidy per fuel

Per unit

Total (Rs crore)

Per unit

Total (Rs crore)

Rs crore

USD millions

Diesel (per litre)†

46.42

33.47

-

-

12.95

34,706

34,706

7,614

LPG (per 14.2 kg cylinder)

721.58

373.43

22.58

1,974

325.56

21,772

23,746

5,210

Kerosene (per litre)

42.31

12.99

0.82

931

28.50

19,484

20,415

4,479

Gasoline†

-

-

-

-

-

2,227

2,227

489

Total

 

2,905

78,189

81,094

17,792

* Prices as of January 16, 2012. 'Desired price' is the sum of refinery gate prices, transport charges and marketing margins paid by OMCs. It is set by a published formula (for the formulae and their latest values for fuels sold in Delhi see http://ppac.org.in/writereaddata/Price%20Build%20up%20Sensitive%20Products.pdf).
'Realised price' is the price charged to dealers (depot price) by OMCs. Retail selling prices in each city are calculated by adding excise duty, wholesalers' and retailers' commission and value-added tax onto the 'realised price' ('unit'= litre, added by this columnist)

†The government 'decontrolled' the prices of gasoline and diesel in 2010 to allow OMCs to regularly adjust retail prices, although it retained authority to approve price changes. Gasoline prices changed in line with the formula, until December 2011 when the government froze gasoline retail prices in order to avoid pass-through of high international oil prices to final consumers, adding to the under-recoveries incurred by OMCs. The gasoline price was increased again in May 2012. Diesel price rises have been much more strongly constrained than gasoline in the period since 2010

Breakdown of who paid for India's fuel subsidies in 2010-11

 

Total

 

Rs crore

USD millions

Government:

Fiscal subsidy
Under-recovery
Total

2,905
41,000
43,905

637
8,995
9,632

Upstream oil companies: Under-recovery

30,297

6,647

Oil marketing companies: Under-recovery

6,893

1,512

As the policy document observes, Anand from the NIPFP finds "perhaps surprisingly, given how much the issue is discussed, that there is little empirical or modelling work to support the debate on the impacts of fuel price subsidy reform on inflation". Three available estimates, the first of which is for crude oil rather than diesel, are:

  • The Reserve Bank of India report in 2011 on crude oil: 'Empirical estimates show that every 10% increase in global crude prices, if fully passed through to domestic prices, could have a direct impact of 1 percentage point increase in overall wholesale price index (WPI) inflation and the total impact could be about 2 percentage points over time as input cost increases translate to higher output prices across sectors.'
  • Anand applies the weight of diesel in the WPI and finds that a 10% rise in diesel prices would lead to a 0.47% rise in the general price level. This is a first-order estimate: we would expect feedback mechanisms to lead to new equilibrium in the economy, with demands changing, and goods, services and factors of production being substituted for each other. This could lead to a significantly different final inflationary figure than that obtained from this first-order estimate. For an increase in the diesel price of 25%, the current value of the under-recovery, the first-order estimate would be for a price rise of 1.2%.
  • Cambridge Econometrics, using its E3MG model, estimates that the removal of diesel subsidies to vehicles using diesel would increase consumer prices in India by 0.7% as a result of additional freight costs and the direct cost of higher personal transport costs.

"Granting subsidies contributes to the fiscal deficit, which in turn also causes inflation. The authors are not aware of studies estimating how large the inflationary impact caused by subsidies' contribution to the fiscal deficit is, nor any work which compares the relative magnitude of the inflationary impact from maintaining subsidies to the inflationary impact the price rises subsidy reform will lead to. It is not even clear as to which impact is larger. India could consider monetary policy interventions such as currency appreciation to manage inflationary impacts, but the scale of the likely impact on inflation does not seem sufficient to justify these."
The jury is out as to whether the UPA government will face up to the challenge in the next several months and raise fossil fuel prices. It seems unlikely, given the drought as well as perhaps -- for the Congress -- an even more frightening spectre: of being thrown out of power soon or voted out in 2014. Nevertheless, these studies provide the required facts and analyses to take the process forward. Who is paying the actual costs of these subsidies, and who is benefiting from them becomes clear as we sift through the studies.
Also see http://www.iisd.org/gsi/introductions-non-experts/citizens-guide-energy-subsidies-india

Disclosure: This columnist has been engaged by the GSI to help with the media outreach for the studies.

Infochange News & Features, August 2012