Is the fuel pricing policy problematic?

A fuel station attendant in Nadia. | Photo Credit: PTI

After a long pause, retail fuel prices have been inching up over the past week and have crossed the ₹100-litre mark again in several parts of the country, while LPG cylinder prices have been hiked by ₹50. India officially has a deregulated pricing regime, but in recent years, this practice has been put on hold during election campaigns. Is the fuel pricing policy problematic? D.K. Srivastava and S.C. Sharma discuss the question in a conversation moderated by Vikas Dhoot:

How has India’s fuel pricing regime evolved in recent years, culminating in the so-called deregulated pricing regime?

S.C. Sharma: The story of dismantling oil prices starts from 1997. In 1995-96, India had an import dependency of about 65%-70%, so the government thought of moving from an administered price mechanism on a cost-plus basis to market-determined consumer prices for petrol, diesel and other fuels. The Nirmal Singh Committee made recommendations in late 1996 and it was decided that the oil pricing mechanism would be dismantled gradually from 1997 till 2002, from 75% in the first year to 100% by April 2002. Ram Naik, the Petroleum Minister in 2002, announced full dismantling as oil prices were comfortable.

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From 2004, oil prices started moving up, and the United Progressive Alliance government restored the cost-plus pricing system to protect consumers. From an average price close to $48 a barrel in 2006, prices moved up each year and peaked at $143 a barrel in 2008. The average price was $69 then. In 2009, prices moved up to $89, and stayed between $100 and $120 till 2014. The government did not pass on the entire price burden to consumers, and subsidised prices for transport fuels, LPG and kerosene through a mechanism to provide for oil marketing companies’ under-recoveries. Till 2009-10, the government had issued ₹1,42,203 crore in oil bonds, but it started providing cash subsidies thereafter till 2014-15. Oil prices came down to about $50 per barrel in 2015, which was a happy situation for the National Democratic Alliance government, which again started implementing the market price mechanism. The prices remained at a low average level of $50-$60 per barrel, so the market price mechanism could be implemented easily without giving much discomfort to the consumers.

The current high prices are largely due to two factors. The higher level of excise on transport fuels has led to higher VAT levies in States, which have in turn increased the prices. The Rupee has depreciated and the share of energy imports has gone from 70% to 86%-87%. The OPEC countries not releasing production quotas since COVID-19, and the Ukraine-Russia crisis, are also key factors for the high prices.

There is a stop-and-start approach to price changes despite a free pricing regime. As soon as elections in critical States are announced, fuel prices are frozen irrespective of global price trends. How does this affect the economy?

D.K. Srivastava: The broader lesson is that the government has not been able to stick to either the earlier regime or the current regime whenever global price pressures have gone above a certain threshold. When the variations are within a certain range, the mechanism has worked, but the moment there is added pressure on global crude prices, there are political economy reasons as well as sound economic reasons for the government to deviate from the stated policy either temporarily or in a more regular way. Even as a de-administered pricing regime was introduced, it was partial to begin with, and there were repeated deviations as soon as global prices rose. So, when prices cross a threshold, we give up. Right now, we say ‘temporarily’, but we have to really revisit this issue because the Indian economy has become vulnerable to global crude price pressures. In fact, if those prices are passed on fully to consumers and industrial users, they will generate major economic effects. High retail inflation now will lead to an adverse income effect, which will lead to a subdued consumption expenditure recovery. After COVID-19, the economy has not been able to recover fully and investment has not taken off because private final consumption expenditure has not fully recovered and there is a very strong adverse income effect. This is having an adverse impact on inflation and growth and the government is now faced with a very serious problem. If it allows this effect to be passed on fully, then post-COVID-19 economic recovery will take more time, because it has to allow consumption expenditure to recover to pre-COVID-19 levels. And if it does not do so, then there are obviously serious fiscal costs. So, who is going to bear the burden of these costs: the Central government or State governments? This is a critical and a long-term issue, because we are not able to manage a meaningful de-administered price over a long period of time and we make short-term compromises again and again.

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In the short term, the only quick solution could be a reduction in excise duties or taxes, which will have a fiscal cost. But the government has had fairly healthy tax revenues this year…

D.K. Srivastava: Yes, in the short run, the tax buoyancy and the prospects for 2022-23 provide certain fiscal legroom to absorb a reduction in excise duty on petroleum products. This kind of buoyancy is also there for States through the VAT on petroleum products, so if the Central and States can come together, coordinate and balance the burden of adjustment among themselves, then there is room to absorb some of the costs. But this is only for the current period. The corporate income tax reforms, the expected reform on personal income tax and the GST reforms all proved to have a revenue-adverse impact, so, the capacity of the Central government to absorb increases in global crude prices became limited even before we hit the COVID-19 threshold. GST is still not revenue-neutral, corporate income tax has still not fully recovered, and if investment does not take place, the expected buoyancy won’t occur. Let us take recourse to the fiscal space available in the short run, but we have to recognise that the tax-to-GDP ratio, particularly of the Central government, has not touched the old peak levels after these reforms. So we continue to live with major constraints.

S.C. Sharma: The government has to choose between healthy revenue generation and giving a fillip to the economy through lower prices. The contribution of the petroleum sector to the exchequer in 2014-15 was ₹ 1,72,065 crore, which went up to ₹4,53,820 crore largely due to enhanced and excessive excise duties. The excise today on petrol is around ₹29 and for diesel, it is ₹23-24. The States have also benefitted with VAT collections having risen. So, it’s a dual effect for consumers. Over the last 25-30 years, one should have diversified revenue generation from different sectors, but if you depend only on the oil sector, it makes a difference to growth and inflation because everyone depends on oil.

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The government has been critical of oil bonds that were issued earlier. Is a direct transfer from the fiscal pool a cleaner way to pay oil marketing companies for losses due to price freezes?

D.K. Srivastava: Obviously, oil bonds are a very inefficient intervention as they only tend to postpone the problem. Oil bonds are inconsistent with meaningful fiscal reforms. Right now, the options of the government are limited because of the lack of a macro vision for fiscal reforms. For example, corporate income tax used to contribute 34.5% of the Centre’s gross taxes in 2014-15. This came down to 22.6% in 2020-21 and is at 25.2% even in 2021-22, which indicates that the government even in this better year does not have the necessary fiscal capacity to absorb the burden of sudden and sharp rises in global crude prices. This is because the timing of fiscal reforms, the rate reduction that led to this massive erosion of growth of corporate income tax, has really tied the hands of the Central government. It is clear that from 2002 onwards, our strategy for dealing with the vulnerability of the Indian economy to global crude price rises on a trend basis has not been developed. So, we actually have a myopic view — when it is a sudden and sharp rise above trend, we develop some short-term measures like these oil bonds. But knowing fully well that the dependence of the Indian economy on imported crude oil has been rising and is now around 85%, and global crude prices are also rising, there has not been any long-term strategy to deal with this. So, all the time, we have short-term measures and our reforms are also not well-coordinated. This is why we keep landing ourselves in such macro situations that are adverse for growth and inflation. We have calculated that if the average oil price in 2022-23 settles at $100 per barrel, the growth rate would fall by 70 basis points, inflation would increase by 100 basis points, Ceteris Paribus. These are major adverse macroeconomic effects soon after the deleterious impact of COVID-19. We have failed to develop the necessary capacity and policy to cope with this well-known trend of increasing dependence and rising global prices on a trend basis. We get lost in the short-term volatility.

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How does this stop-and-start pricing approach for fuels affect interest from global investors in the oil and gas sector or bidders for BPCL?

D.K. Srivastava: It is definitely a red flag because investors study closely governments’ behaviourial responses to various kinds of shocks that emanate from the world economy. Everybody understands that this policy may not be resorted to for some time, because there are no elections around the corner. Investors also look at the prospects of the Indian economy and capacity utilisation. Unless the capacity utilisation ratio increases to something like 75 or 80, new investment decisions will be postponed, and the cycle can only be turned by reviving consumption expenditure. Passing through higher oil prices will dent investments as well as consumption through cost escalation and income shocks. So, we have a vicious circle for policymakers right now.

S.C. Sharma: Oil and energy are essential commodities and the government doesn’t want to completely let the sector out of its hands because any supply disruption impacts the country’s mobility and the economy’s health. Over the last six-seven years, the stop-and-start pricing policy and reforms towards a market price mechanism, if the government control on pricing was 90% in the previous 20 years, has become 10% to 15% now.  

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Should the Model Code of Conduct include the deferral of routine administrative decisions such as revision of oil prices or small savings rates?

D.K. Srivastava: This is desirable, but it cannot happen unless the decision of determining the price goes to some independent body. I do’'t think any government would be willing to give up whatever little legroom it has. We need to develop a proper medium-term growth strategy with taxation of petroleum products as a critical ingredient. Petroleum products are highly polluting, so we have a long-term trend of increasing tax burden on their users. But that long-term path should be determined. As long as we are seeing this prospect of continued high dependence as well as continued high prices, despite the move towards non-conventional energy sources, we have to really increase our tax-to-GDP ratio from other sources. Unless that is done, we will be dealing with various versions of stop-and-go pricing.

S.C. Sharma is former adviser (petroleum) at the erstwhile Planning Commission and has worked extensively on India’s energy challenges; D.K. Srivastava is chief policy advisor at EY India, former director of the Madras School of Economics, and member of the 12th Finance Commission

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Printable version | Apr 25, 2022 10:07:24 am |