Tuesday, August 28, 2012

Tyranny of diesel subsidy:
Rs. 40,000 crores loss by OMCs

Dr. Bhamy V. Shenoy

If politicians are given the choice of improving education, health, and water facilities to the poor or subsidizing diesel, the choice should be obvious without any controversy. Still diesel subsidy is on its way to become a sacred cow for the political class. Why? How? What should be done to eliminate this subsidy which has been one of the reasons for the unanticipated decline in India’s growth rate from above 9% to around 6%.?

Environmental harm caused by diesel subsidy in terms of contributing to global warming directly and indirectly is not even mentioned. The increasing share of diesel vehicle sales is often discussed. Since diesel is relatively cheap (about Rs 25 per liter) compared to gasoline, the share of diesel vehicle sales is increasing.

When three high level committees all headed by eminent economists (C. Rangarjan, B. K. Chaturvedi and Kirit Parikh) were asked to look at the problem of petroleum subsidies during 2006-2009, only residential LPG and PDS kerosene were subsidized in a formal way to help the poor. All these committees had recommended that not only the government should get out of the business of setting product prices, LPG and kerosene prices be also liberalized,. They recommended that the poor could be supplied with subsidized products through coupon or smart card system while allowing their prices to reflect international markets.

The UPA government did not show any interest in implementing these recommendations. There has never been a deliberate policy to subsidize diesel. But the paralysis on the part of UPA to take action in liberalizing diesel pricing has resulted in ever increasing losses to oil marketing companies (OMCs). I have been predicting for some time that these navaratna OMCs will face bankruptcy unless the pricing regime is liberalized.

Currently OMCs are incurring under recoveries from diesel alone of more than Rs. 1,30,000 crores per year. Such a mind boggling amount can easily pay for expanding Sarva Sikshana Abhiyan to improve education, Integrated Child Development Services to help poor families, National Rural Health Mission to improve the operations of rural clinics etc. 2012-13 budgets for these flagships welfare measures are Rs.25,555, 15,380 and 20,822 crores respectively.
The political class is reluctant to liberalize diesel pricing. This is driven by the mistaken notion that such a policy will affect the poor. Computation of under recoveries is faulty.

One question that is always raised concerning diesel price increase is its impact on inflation. Consumers of diesel can be classified under seven categories to study this problem. These are: trucking, private cars, buses, railways, agriculture, power and industry with their respective shares being 37%, 15%, 12%, 6%, 12%, 8% and 10% respectively.

When diesel price is increased, the cost of transportation will certainly go up. This is because railways and bus companies will increase fares to recover their additional costs. So also there will be increase in the price of goods because of the cost of transporting them in trucks. Electricity cost will also go up for those who use diesel to generate power. Cost to the farmers will go up. However when we look at the total impact it is easily manageable as shown below. What is of great interest is that the poor are affected the least. This is because the poor are not part of the formal economy. They are affected more from general inflation caused by fiscal deficit than from diesel price increases.

Let us analyze how each sector is impacted by eliminating the current under recoveries of Rs. 13.89 per liter of diesel. Of course it is neither advisable nor politically feasible to eliminate the under recoveries in one go and should be done gradually. Trucking diesel accounts for 35 to 40% of their total cost and diesel increase will raise their cost by 12.8%. But its impact on final consumption is only about 0.64% since trucking cost accounts for only 5% of the total cost of the goods we consume. When we compute the increases in final consumption for other sectors, private cars, buses, railways, agriculture, power, and industry, the figures are 9.6%, 11.2%, 7.0%, 0.3%, 21%, 4%.

The impact on industry and agriculture is minimum since diesel cost accounts for just 1.1% and 0.8% only. Since it is mostly the rich farmers who use diesel pumps, they should be in a position to pay for the increased cost. In the case of trucking too the inflationary impact on goods carried will be only 0.64% since trucking cost accounts for only 5% of the final cost of the goods. Still it is the trucking sector which makes the loudest noise by threatening to strike when diesel price increases. But they not only pass the incremental cost of diesel price increase, they overcompensate because of their monopoly position.

Power sector will have the maximum impact. But it is mostly those who use diesel generator sets who will be affected by this increase. Industrial consumers have the option of running generator sets based on economics. For householders who use standby generators, the additional cost is not a big burden at all since it is only the rich who can afford diesel generator sets. The same is the case for owners of private cars who can easily absorb the increase of 9.6%.

Since total diesel cost accounts only for about 3.45% of GNP, increase of diesel price by Rs 1 per liter will have minimal impact on overall inflation of about 0.08%. This is only first order inflation impact. However as a result of passing this cost of incremental diesel prices through different stages of the value chain through the economy, it is bound to be higher but still manageable. Even if diesel price is increased by Rs 14 per liter to eliminate all under recoveries the total impact will be just 1.1%. This is just first order impact, without considering the cascading impact of diesel prices which will push the resultant inflation higher.

However as a result of diesel under recoveries (about Rs 2.4 lakhs during the last seven years) the impact on fiscal deficit is likely to be far more. The inflationary impact of such a massive deficit is likely to be more than the inflationary impact of diesel prices.
The Achilles heel of diesel liberalization is the credibility of under recoveries. With the declaration of an unprecedented loss of Rs. 40,000 crores by OMCs for the first quarter of 2012-13, critiques need to find some other explanation to support the diesel subsidy. It is true that when the government compensates OMCs for their under recoveries (government pays about 30%, upstream public sector companies pay 30 to 40% and the rest is absorbed by OMCs), these losses would come down.

Still there is a basic question. When the government pays for the losses incurred by the oil companies, who actually is the loser. All of us know that there is no such thing as a free lunch and the actual loser is the common man who has to bear the burden of higher inflation. When the government pays for under recoveries, the fiscal deficit increases resulting in higher inflation. On the other hand if OMCs are not reimbursed, they will go bankrupt and every one will suffer. Vote bank politics does not worry about such disasters as has been amply demonstrated by the recent grid failure. No one has attributed it to the power sector subsidy.

In recent months highly placed technocrats like the deputy chairman of the planning commission Montek Singh Ahluwalia, PM’s economic advisor C Rangarajan, RBI’s governor Subba Rao have been saying that India cannot afford the diesel subsidy. Many seminars have been held on oil sector subsidy to recommend their removal and to improve subsidy delivery system through Aadhaar, coupons, etc. But there has been no political will to liberalize petro product prices. We are always waiting for the next political events like elections to be over. It is high time that we have some out of the box type of action plans.

Despite the shocking levels of losses why have chairmen of the OMCs not threatened to resign rather than preside over a process which is sure to bankrupt their companies? Such a sacrifice can be considered as a modern corporate form of satyagraha to prick the conscience of our political system.

Along with them others in the government who deal with the petroleum sector like deputy chairman of the planning commission, petroleum minister, petroleum secretary, PM’s economic advisor etc should also threaten to resign. That may create a political tsunami and help bring about the needed liberalization of diesel pricing. In the overall interest of India’s development, this may be a small price to pay. It may finally start the process of eliminating the diesel subsidy.

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