Urgent need to get rid of subsidies

Petroleum subsidies have not only impacted the financial health of the public sector oil marketing companies (OMCs) but also put a strain on the central government's finances. There is an urgent need to get rid of fuel subsidy except for certain weaker sections of the population. But equally important is market-determined pricing of petroleum products.

Petroleum pricing in India has a chequered history. In the early 1990s, economic reforms witnessed the setting up of the Strategic Planning Group on Restructuring of Oil Industry (R-Group) in January 1995 to make recommendations for developing a financially sound and internationally competitive hydrocarbon sector taking into account the need for investments in technology upgrades and improving efficiency and competitiveness of the oil industry.

The R-Group concluded that: APM (administered pricing mechanism) provided a degree of insulation to the domestic prices against volatile international prices. APM helped oil companies to grow in a protected environment. However, APM did not allow generation of sufficient financial resources for oil companies to make the required investments for energy security. The APM did not provide incentive either for cost minimisation or for technological improvements. Since all costs were reimbursed there was no incentive to make profitable investments. The subsidies and cross subsidies built in the APM resulted in wide distortions in consumer prices. Lack of transparency was detrimental to much needed private capital as well as foreign direct investment. Hence, to achieve the objective of securing oil supplies to meet the future growing demand, it would be absolutely necessary to move towards a market driven price mechanism and to free the petroleum sector from APM”.

Finally, in November 1997, the government announced the phased programme for dismantling of APM during April 1, 1998, to March 31, 2002. With the implementation of the programme, pricing of crude oil and petroleum products moved towards market driven prices except for domestic LPG and PDS kerosene, for which the government fixed specific subsidies, to be phased out over a period of three years starting April 1, 2002. In practice, however, the government did not follow the announced policy of allowing increases in prices of domestic LPG and PDS kerosene arising out of increases in FOB price, sea freight etc, to maintain specific subsidies from the beginning of the dismantled APM era, i.e., April 1, 2002, resulting in under-recoveries to OMCs. For petrol and diesel, OMCs began periodically fixing retail selling prices. This continued till the steep increase in international prices was experienced in the later part of 2003.

Thereafter, the government once again informally started controlling retail prices of petrol and diesel. Petrol, diesel, domestic LPG and PDS kerosene, for which the government controlled prices, accounted for about 63% of the total quantum of petroleum products' consumption in the country. Although the government allowed ad-hoc revisions in retail prices they were not commensurate with the international prices. OMCs continued to suffer under-recoveries. As a consequence, OMCs began accumulating huge under-recoveries, threatening continuation of their operations. The magnitude of under-recoveries in 2008-09 alone was over R1 lakh. Through ad-hoc measures like sharing of burden by upstream PSUs, national budget, issuance of oil bonds (discontinued from 2009-10), the government barely managed to protect the OMCs from sinking.

The ad-hoc interventions by the government and the mounting under-recoveries have had their consequences. First and foremost has been the adverse impact on the profitability and cash flows of the OMCs, which have not been reimbursed fully the under-recoveries and need to bear part of the amount. Further, prior to 2008-09, reimbursements were in the form of discounts and oil bonds, which adversely affected their cash flows. Oil bonds were discontinued from 2009-10 and the government decided to meet part of subsidy from the national budget. These bonds have been made available with a time lag, for which OMCs do not receive any interest. This adverse impact on cash flows of OMCs has resulted in increased borrowings, implying increased interest costs . Moreover, the oil bonds could be sold only at a discount, which further impacted their profitability.

Second, the profitability of the PSU upstream companies has suffered badly as they have to share a sizeable amount of the under-recoveries. Third, the under-pricing of these four fuels has led to inefficient usage of these fuels, adulteration of diesel with kerosene, diversion of domestic LPG for commercial purposes and inter-fuel substitution. Under-pricing in relation to prices in the neighbouring countries has encouraged cross-border smuggling.

And finally, the subsidised pricing system has resulted in the lack of private sector participation in marketing of these fuels, as they cannot afford to market these products in the absence of subsidies to them. As a result, the consumer is denied the benefit of competition and oil PSUs continue to be dominant players.

Tags: reforms, petroleum subsidies, petroleum, oil companies