Rationalizing energy

At the backdrop of the present government creating a focus on phasing of subsidies on petroleum products, the need for assessing the socio economic implications of such phasing out has gone up. Currently, as of September 01, 2014, diesel is almost deregulated. Under-recoveries on diesel stand at 0.03 INR/litre. Diesel contributes the most (45%) to under-recoveries - IMR 62,337 Crores in a total of lNR 1,39,369 crores.

With this premise, an on-going study in The Energy and Resources Institute (TEPJ) can provide valuable inputs and will be able to buildup policy relevance for decisions related to subsidy phasing out in petroleum products impacting the energy prices.

Under the on-going project titled 'Rationalizing Energy Pricing in India', TERI is studying the distortions in energy pricing in India and its impact on energy access and overall welfare of the society. Considerable literature exists on the assessment of energy subsidies in India. However, most of the analyses have been limited to specific fuels or the impact of subsidies on particular demand-side sectors. Therefore, this study builds up on that and aims to reveal the impact of changes in fossil fuel subsidies and prices on the sectoral energy demand, fuel substitution possibilities and household welfare.

Some of the highlights of the study are:

- Inventorization of explicit, implicit subsidies in the value chain of fossil fuels

- A flow 'chain of subsidies within the entire value chain of different fossil fuels

- Assessment of impacts of change sin fossil fuel subsidies and taxes on household welfare, income distribution across household classes, fiscal deficit of the macro-economy, macroeconomic indicators of the economy through general equilibrium models

- Contextualizati on of the impacts, assessments of fossil fuel related tax subsidy changes for policy relevant decision making and road map
DEW Journal takes a closer look at this study and talks to TERI expert Anandajit Goswami, Fellow and Saahil M Parekh, Research Associate working on this project to find out in details what the various issues discussed in the study stand for.

Inventorization of explicit, implicit subsidies in the value chain of fossil fuels.

We need to understand - "Why it is important to inventorize explicit arid implicit subsidies?" The need for inventorization is to know how much subsidy exists arid whether it can increase/decrease in order to take future actions for reducing them. Heed for reduction of subsidies arises from the fact that presence of subsidies can give false signals to the economy. It can enhance energy co resumption arid can lead to larger pollution. They also have an effect of draining out the fiscal resources. Accelerated energy consumption triggered by subsidies for maintaining the engine of economic growth can bring negative externalities in terms of larger environmental challenges arid re source exhaustion by not following the geological laws of nature arid finiteness of natural resources.

It can also enhance the exhaustion of resources and therefore raise the chance of an economy to de grow in future. This is because e the growth of modem economies are strongly coupled with energy consumption even though alternative energy resources are being looked at. Therefore for a balanced growth path (by respecting the finiteness of natural resources) of an economy subsidy inventorization is important as it can help in taking actions to reduce subsidies arid thereby can send strong signals to reduce excess energy consumption.

Moreover, subsidies are directed to fossil fuels like diesel which consumes a large part of the income expenditure basket of higher income classes of the country in comparison to low income classes. Therefore presence of subsidies creates an inequitable resource allocation for the country. This becomes truer for a country like India, where the indirect benefits of subsidies in fossil fuels like kerosene, LPG, petrol arid diesel go to a large extent to higher income classes. These indirect benefits from fossil fuel subsidies drop as we go down towards the lower income classes.

While doing an inventorization of subsidies, two kinds of subsidies need to be considered. These are the producer and consumer subsidies. Producer subsidies are generally measured against the international reference prices. Consumer subsidies can be further divided into pre arid post-tax subsidies. Pre-tax subsidies arise when the consumer prices are lesser than the cost of supplying any energy. Post tax subsidies arise when they are below an efficient level after including tax measures to offset externalities. Globally, post tax subsidies have been four times higher than the pre tax subsidies which indicates the nature arid degree of externalities ere ate d by fossil fuel usages. With this background, it is important to know some of the explicit arid implicit subsidies that exist in the context of India. Explicit subsidy includes direct money transfer and spending. Categories of this type of spending c art include - price support, earmarks, R&D grants, ownership of natural resources to provide or produce energy, credit support through government loans below market rates, subsidized credit provision to domestic infrastructure, tax breaks, income tax holidays, arid relaxation of custom duties.

Implicit subsidies can include provision of energy carriers or fossil fuels below market prices. This can again include free lease of oil and gas sites, some of the direct cash transfer projects like the IOCL pilot cash transfer project. It can also include a subsidized provision of any input that is used in the production of fossil fuels.

However, the debate still stays on whether these support structures can be called as subsidies at the first instance.

A flow chain of subsidies within the entire value chain of different fossil fuels

It is clear that fossil fuel subsidy entails provision of the fuel at a price below the cost of supply This means a loss of money which is not recovered or it can be seen as an outflow within a system of value chain of fossil fuel starting from the upstream to downstream consumers.

Currently under pricing exists for all range of fossil fuels viz. kerosene, LPG, petrol and diesel. An ongoing work related to impact of rationalization of fossil fuel taxes and subsidies conducted by a team at TEPJ and supported by DFID gives a hint that if we consider the value chain of a fossil fuel like LPG, an outflow of close to 60% happens from the government to the end consumer households. 31% outflow happens from the upstream segment of the value chain of LPG to the end consumers and finally 12% takes place from OIvCs to households. Another way to see this is - "Around 57% of the subsidy burden is borne by the government, 31% by upstream companies and 12% by oil marketing companies" in case of LPG. The inequity aspect of this subsidy arises from the fact that the highest income bracket of the country consumes more LPG than the lower income classes and therefore the fruits of this subsidy burden is enjoyed by these segments.

Therefore, the next set of question is what will happen to the highest income classes if these subsidies are removed.

Assessment of impacts of changes in fossil fuel subsidies and taxes on household welfare, income distribution across household classes, fiscal deficit of the macro-economy, macroeconomic indicators of the economy through general equilibrium models

Within TERI, an ongoing research conducted by a team of researchers working on Social Accounting Matrix based CGE modeling exercise shows that removal of subsidies is going to impact the richer income classes of mb an and rural society more than the lower income classes of both rural and urban areas of the country. The impact can happen in terms of a welfare or indirect income benefit losses for the richest income classes in rural and urban society. However, if the loss is compensated by gains for the lower income classes of rural and urban areas through adequate redistribution measures then it might be beneficial for the country as a whole.

The government has already taken initiatives in these lines of redistribution of subsidies and benefits for the poor households. Some of them are indicated through the policy signals of Aadhaar based direct cash transfers, limited supply of LPG for every household, increase in diesel prices and heavy taxation of petrol. With regard to government led reform measures, India can internalize learnings from some of the success stories of subsidy reform measures in fossil fuels. One such success story deals with the case of subsidy policy reform in Uganda.

A key aspect of the reform measures deal with contextualization of impacts related to rationalization of fossil fuel subsidies which can be further fed to policy relevant decision making through a road map for such reform.

Contextualization of the impacts, assessments of fossil fuel related tax subsidy changes for policy relevant decision making and road map

Some of the key aspects of such reform measures deals with an estimation and assessment of the extent and nature of the gainers and losers emerging out of the fossil fuel subsidy reform process in India. By assessing who wins and loses, an appropriate strategy needs to be worked out on how the losers can be compensated and taken along in a strategically designed sequential reform process of fossil fuel subsidies in a developing country like India. An important component of such a process will be continuous stakeholder consultation, informed and transparent communication to all stakeholders. It will also involve a step by step sequential targeting of different fossil fuel products. One of the measures will include depolitization of tariff setting of fossil fuel products. For instance, if we take electricity, the gap between the actual cost of supply and electricity tariff has created regulatory assets in several states of the country. As per the national tariff policy of the country, regulatory assets have to be reduced by setting the power tariffs rightly and matching with the average revenue requirement of the companies. This has not happened in certain states though some have been able to achieve a reduction in regulatory assets too.

Therefore, time has come to consider these state specific realities in an implementable fossil fuel subsidy reform road map of the country.

Regulatory assets - case of Tamil Nadu which needs to do a lot more whereas states like West Bengal have done well.