CUTS' Memorandum to the Hon’ble Finance Minister

Discussion on ‘Petroleum Subsidies’
30th May 2005, New Delhi

The National Common Minimum Programme (NCMP) of the Government, inter alia, states:

All subsidies will be targeted sharply at the poor and the truly needy like small and marginal farmers, farm labour and the urban poor.

Petroleum Subsidy comprises of:

  • Subsidised Domestic LPG
  • Subsidised Kerosene for PDS

Extent of subsidies and under-recoveries

The petroleum subsidy is estimated at Rs.6573 crores in 2003-04, up from Rs.5225 crore in 2002-03.

Besides, the gross under-recovery on petrol, diesel, LPG and kerosene was Rs.20,310 crore in 2004-05, which is borne by the oil industry including upstream producers, mid-stream firms and downstream companies, and private refiners. Taking into account the designated announced subsidy and the import parity cost, the oil companies are losing nearly Rs 100/cylinder for LPG and Rs 2.5-3/litre for kerosene.  The subsidy under-recovery, however, is set to decrease in 2005-06 on account of the reduction in customs and excise duties and drop in international prices.

Distortions in the Pricing of Petroleum Products, and in Calculation of Subsidies

  • A major oil sector reform has been the abolition of the administered pricing mechanism (APM) with effect from 31 March 2002. However, it does not give market forces the complete freedom to fix the price, as the price revision has to be discussed with the Government, each time.

Is there a subsidy burden?

  • The present system of working out the extent of subsidies itself is notional on the basis of import parity pricing of petroleum products and not on the basis of unrecovered costs, which is the appropriate figure for calculating subsidy.
  • The government imposes a cess on indigenously produced crude oil. The Oil Industry Development Act, 1974 based on which the cess is being charged, states that "the cess collected under this provision would be made available to the development of petroleum sector". The cess was introduced to provide financial assistance to state-owned oil companies, and is not applicable to private oil producers. Over the past three decades, the government has collected Rs.50,000 crore as cess, but only Rs.902 crore has been allocated to the Oil Industry Development Board (OIDB) that is supposed to disburse the money to the industry. The balance money has gone to the Consolidated Fund of India. The cess was doubled in 2002 from Rs.900 a tonne to Rs.1800 a tonne, on the ground of providing subsidies on LPG and kerosene (the cess was never intended to cover subsidies). This helped raise an annual amount of about Rs.6000 crore in 2002-03 and 2003-04. Now that the petroleum sector has been deregulated and opened for private sector, there is no justification of continuing this cess at all. The cess amount now seems to be an implicit arrangement of meeting the subsidy burden and containing government’s deficits. Considering the amount of cess, the net petroleum subsidy seems to be negligible.
  • Oil is a highly taxed sector. Taxes take different forms – excise duty, additional excise duty including different cesses levied to raise funds for specific purposes such as road construction, and State taxes. The total tax revenues from the oil sector stood at Rs.110,000 crore in 2003-04 (Rs.69,000 crore went to the Centre, and remaining accrued to the states in the form of sales tax). Compared with other Asian economies, India’s levies on oil tend to be high. The taxes on crude oil and natural gas add to the production cost of kerosene and LPG and inflate their subsidy bill. In addition, a part of the cost of LPG and kerosene is made up of sales tax and excise duty. This further inflates the petroleum subsidy bill.

Are oil companies losing out?

  • Oil companies charge buyers of both petrol and diesel ‘adjusted’ import parity price. This formula of arriving at the retail price came into effect after the government dismantled the administered price mechanism in April 2002. Accordingly, the customs duty on imported petrol and diesel is factored in, to arrive at the import parity prices of petrol and diesel. Incidentally, the country does not import petrol or diesel as the production is more than the total domestic demand. So, no customs duties are paid but this levy is added on to the base price to avail of the protection that is offered under the policy of import-parity pricing. It is estimated the oil companies garnered an additional Rs.9866 crore in 2003-04 on account of the notional customs duty. This was not paid to the government, as the amount is not collected from the consumer as customs duty.
  • The Planning Commission in its mid-term appraisal of the sector for the 10th FYP has criticised the pricing methodology based on import parity, which provides higher margins to the refiners thereby resulting in large profits.
  • Additionally, oil companies factor in costs incurred on account of ocean loss, letter of credit charges and port charges. Again, these are largely notional costs.
  • In 2002-03, it was estimated that oil companies made net profits of around $19.5 on every barrel of oil that reached the public. These profits are very high as compared to international standards – most international companies earned net profits of between $0.62 and $1.38 a barrel during 1999-2002. Anyhow, the high profits are considered necessary to build in high margins, as the government still controls the prices of petrol and diesel and does not allow the companies to raise rates when crude oil becomes costly internationally. Further, oil companies are forced to absorb losses on subsidised cooking gas and PDS kerosene. Another reason for high profits in petroleum is due to the monopolistic practices of state-run PSUs, as per a discussion paper of the Oil Ministry.

Competition Stifled

  • A significant step towards introducing competition in the down stream value chain, in the Indian petroleum sector, was the decanalisation of kerosene (SKO), LPG and LSHS products. From 1993 onwards, private parties have been allowed to import, as well as market, these products at the prices determined by the market forces, in parallel to the PSU dominated marketing system. The new entrants are expected to develop infrastructure for imports of these products, tankers for storage, LPG Bottling plants, in addition to setting up their own distribution and marketing network including, transportation arrangements.
  • In order to maintain its distinction from the Kerosene supplied by the parallel marketers, the PDS kerosene has been coloured with blue dye. Furthermore, the LPG Control Order has specified that the cylinders, regulators and valves to be used by the parallel marketeers have to be distinctively different from that used by the public sector oil companies. The latter is an anti-competitive requirement. It reduces the freedom of LPG end-users in switching from one supplier to the other.
  • Furthermore, only public sector companies are allowed to market subsidised petroleum products. While there may be some genuine, social concerns that Government has to take care of, the non-targeted subsidies offered to PSU oil companies in terms of concessional pricing, distorts the market, making it difficult for private firms to cater to these segments and also restricts their ability to compete effectively.

The pricing structure of various petroleum products is not transparently determined. Government’s intervention is distorting the process of arriving at market-determined prices. The public-sector companies and the government are minting money from distortionary policies and practices. The claim of huge subsidy burden and bleeding oil companies seems to be exaggerated.

Alternative System Proposed

  • There is a strong case for the Government to directly support the needy people, rather than canalising through oil PSUs, which distorts the market process. To ensure that the assistance provided does not destroy the incentives for self-reliant efforts, the subsidy program should be temporary, as an interim measure to protect certain groups from the adverse effects of macroeconomic or sector adjustment on prices.
  • The subsidy on kerosene, to the extent it is used by rural households for lighting purposes should be linked with rural electrification.
  • Import-parity pricing regime should be dismantled and oil companies allowed to charge market-determined prices.
  • Overhaul the prevailing tax structure. Replace the current ad valorem duty structure with a specific one. This will remove the cascading effect of a rise in oil prices. A price stabilisation fund may be created to check high volatility of crude prices. The fund could be resourced from the cess collected under the Oil Industry Development Act.
  • Remove the anti-competitive provision of the LPG Control Order. The petroleum sector requires a comprehensive competition framework rather than stringent regulations.
  • Establish the Petroleum and Natural Gas Regulatory Board
  • These measures will bring transparency in the determination of petroleum products, ensure that market forces are allowed to operate, and facilitate proper targeting of subsidies.

 

I. General Issues

Concerns/Distortions

Suggestions made in the report/background note

Remarks
  • Though APM was abolished in 2002, government continues to play a major role in determination of prices of petroleum products.
  • There is lack of transparency in the determination of prices
  • The system of calculating the extent of subsidies itself is notional on the basis of import parity pricing of petroleum products and not on the basis of unrecovered costs
  • Only state-owned oil companies have been permitted to market subsidised domestic LPG and PDS kerosene. This has stifled competition by curtailing the entry of private retailers
  • Government’s intervention in the oil sector is impeding the market process. There is need to rationalise government’s intervention in the sector and target sharply the subsidies at the poor and the truly needy
  • A market environment encouraging fair and healthy competition is the most effective way to expand the supply and availability of competitively-priced kerosene and LPG.
  • Import-parity pricing regime should be dismantled and oil companies allowed to charge market-determined prices.
  • Overhaul the prevailing tax structure. Replace the current ad valorem duty structure with a specific one. This will remove the cascading effect of a rise in oil prices.
  • A price stabilisation fund may be created to check high volatility of crude prices. The fund could be resourced from the cess collected under the Oil Industry Development Act.
  • Remove the anti-competitive provision of the LPG Control Order. The petroleum sector requires a comprehensive competition framework rather than stringent regulations.
  • Establish the Petroleum and Natural Gas Regulatory Board
  • Ensure that prices of petroleum products are determined transparently

II. Subsidy on Domestic LPG

Concerns/Distortions

Suggestions made in the report

Remarks
  • LPG subsidy benefits largely the higher expenditure groups in urban areas
  • Black marketing of domestic gas cylinders
  • Unauthorised use of domestic LPG for commercial purposes and automobiles
  • Removal of LPG subsidy in a gradual manner, or at least a substantial reduction in the subsidy element, may be recommended
  • Government has decided to raise the cooking gas price by Rs. 5 a cylinder every month starting December 2004.
  • Delete the anti-competitive provision in the LPG Control Order which specifies that the cylinders, regulators and valves to be used by the parallel marketeers (private players) have to be distinctively different from that used by the public sector oil companies. This reduces the freedom of LPG end-users in switching from one supplier to the other.
  • Remove taxes/levies that inflate the cost of providing cooking gas and inflate the subsidy bill. Facilitate prices to be determined by competitive forces.

III. Subsidy on PDS Kerosene

Concerns/Distortions

Suggestions made in the report

Remarks
  • On a per capita basis, the urban areas receive a larger subsidy on kerosene
  • The limited availability of subsidised kerosene in rural areas biases its use in favour of lighting rather than cooking
  • The kerosene subsidy in rural areas is regressive as higher expenditure groups receive more subsidised kerosene than lower expenditure groups
  • Kerosene subsidy is prone to misutilisation with about half of the subsidised kerosene supplies diverted and never reaching the intended groups. Hence, it is not affordability, but non-availability that is restricting the use of clean fuels like kerosene by poor households.
  • Kerosene reaches the consumer through kerosene dealers appointed by the public sector oil marketing companies. The companies deliver kerosene to the retailers (dealers) from their marketing installation points. However, this arrangement does not ensure smooth supply of products. This also leads to leakage of the product for adulteration with diesel.
  • A cautious approach is justified in the reduction of kerosene subsidies since about a half of the rural households use kerosene primarily to light their homes
  • Create an open and competitive market with clearly defined and well-enforced rules and regulations for all participants, to expand access and improve the quality of service
  • Channel all sales of kerosene through the retail markets, and encourage small distributors of fuels.
  • Coupons may be issued only to poor ration card holders with entitlement to purchase kerosene from a retailer at the subsidised price. This would discourage direct diversion of subsidised kerosene to other sectors.
  • PRIs/NGOs should be involved in monitoring of kerosene distribution system. They should be involved in the task of identifying beneficiaries for coupons. They should be roped in to create awareness among consumers about their entitlements under the programme.
  • Grievance redressal system should be established.
  • NGOs should conduct social audit of the schemes, and report misuse of funds.
  • Make the list of beneficiaries publicly available and accessible to all
  • Subsidy on kerosene should be linked with rural electrification
  • Remove taxes/levies that inflate the cost of providing kerosene and inflate the subsidy bill.