Petroleum Subsidies

A Case Against Subsidies

Contents
Objective Literature Review Introduction/Theoretical Framework Analysis Results Conclusion Way Forward

Objective of the Study

The objective of this project is to study: what fuel subsidies are, how do they impact economies and the issues facing them! This project also aims to take India as a case study and looks at the pricing of petroleum products as it has evolved over time, and the ramifications of the pricing regimes on various stakeholders It helps to calculate how the under recoveries are made and the extent of such under recoveries and concludes by suggesting a way forward

Literature Review
Pricing is one of the most effective instrument in influencing the consumption and production of a commodity Pricing can also affect the technological development and innovation Subsidies and pricing are closely linked The key to efficient energy pricing (including the provision of subsidies) lies in being able to track the supply chain of energy and the consumption pattern exhibited by various consumer groups Several studies examine the macroeconomic costs of energy subsidies in developing countries. On the benefit side, the World Bank finds that in general quantity-based utility subsidies tend to be regressive because their use increases with income (Komives et al., 2005) Many case studies in various developing countries examine the income benefits or the progressivity of household fuel subsidies (Dube, 2003; Gangopadyaya et al., 2005; Hosier and Kipondya, 1993; Kebede, 2006; Komives et al., 2005; Morris et al., 2006; Olivia and John, 2008; Pitt, 1985) Piketty and Qian, 2009 discuss that these subsidies are often justified as instruments of redistribution in many developing countries, in part because of the lack of broadbased institutions that enable direct cash transfers A recent study of the implications of distribution of fuel subsidies in developing countries by Granado, Coady, and Gillingham (2010) shows that the benefits of fuel subsidies accrue mainly to higher income households, with the richest 20% receiving six times more in subsidies than the poorest 20%.

Theoretical Framework

What is Subsidy!?
The dictionary defines subsidy as a sum of money granted by the government or a public body to assist an industry or business A subsidy can be interpreted as a reverse flow (transfer) from the government to the public or an income/consumption supplement for individuals Subsidies may be proportional, lump sum or progressive, just like indirect taxes can be Subsidies should be assessed by their relative efficacy, sector efficiency, and costeffectiveness

Subsidy can have three different interpretation- The first term as used by a layman, that is that of explicit budgetary subsidies. The second is the concept used in National Accounts and this implies the converse of indirect taxes. The third is the concept used to refer to unrecovered costs of providing non-public goods

Fuel subsidies are inefficient and a fiscally expensive approach to protecting the poor from rising international fuel prices. However, eliminating fuel subsidies can still have a sizeable adverse impact on poor households Petroleum Products pricing is influenced by every major government in almost all the countries, either directly or indirectly Pass-through defined as the absolute change in domestic prices as a proportion of the change in international prices- has varied a great deal in this period For gasoline and diesel respectively, around two-thirds and one-half of countries could not fully pass through international price increases during the period of 2008-09 Petroleum product tax revenues decreased in 73 countries, with the decrease exceeding 1% of GDP in 41 countries. Subsidies increased in 27 countries, with the increase in subsidies exceeding 1% of GDP in 22 countries tax-inclusive subsidies increased from $406 billion to nearly $1,000 billion over this period, equivalent to 1.3% of global GDP- Emerging economies accounted for over half of these subsidies

Thus, fuel subsidy reform could make a significant contribution to fiscal consolidation efforts in these countries!!

Indian Petroleum Industry at a Glance

CONSUMPTION ('000 MT)

70000 60000 50000 40000 30000 20000 10000 0 2006/07 2007/08 2008/09 2009/10 2010/11 LPG MS

EXPORTS ('000MT)
LPG PETROL KEROSENE DIESEL 20335

18451 14,308 14720 9771 4,258 99 137 2007/08 5440 109 77 2008/09 131 46 2009/10

11,369
8,504 2,417 53 121 2005/06 3,615 112 150 2006/07

13578

SKO
HSD

154 33 2010/11

IMPORTS ('000MT)
LPG PETROL KEROSENE DIESEL 69300

PRODUCTION('000MT)
90000 80000 70000 60000 50000 40000 30000 20000 10000 0 2005/06 2006/07 2007/08 2008/09 2009/10 2010/11 LPG PETROL KEROSENE DIESEL

49670
40,871 29,198

50930 49480

31203

17810 15,888 13,614 10,191 8,700 8,324 8,072 7,042 6,583 8,329 5,843 5,766 4,939 4,250 2,909 2,617 2005/06 2006/07 2007/08 2008/09 2009/10 2010/11

18,654

Impact of the current pricing policy

On the Economy

The government compensates the OMCs in two waysby issuing oil bonds and by providing budgetary subsidies the budgetary subsidies are only about 3% of the total under-recoveries The oil bonds constitute a significant portion of the total under-recoveries These are issued with a maturity period of 57 years and are treated as an off-budget expense and have a direct and immediate fiscal impact on the economy In 2008/09, the fiscal deficit for the country stood at 6.62% of the GDP (with inclusion of the oil bonds) that grew to 8.06% (Reserve Bank of India 2010) as a result of high rises in crude oil price in 2008-09 In February 2009, the international ratings agency 120000 103292 Standard & Poors (S&P) downgraded Indias long 100000 term sovereign credit rating from stable to 77123 80000 Budget Subsidie negative. This was done on account of worsening 60000 Under Recoverie government budget deficit 49387
40000 40000 20000 Linear (Under Recoveries)

2683
0

2699

2820

2877

2005/06 2006/07 2007/08 2008/09

On the Oil Industry

The national oil companiesboth upstream and downstreamare affected by the pricing policy. From 2005/06 to 2008/09, the under-recoveries have risen significantly. Within a period of three years, these have increased from `400 billion (2005/06) to `1032.92 billion (2008/09), growing annually at a rate of around 37% The oil bonds provided by the government are an inefficient mechanism of financing the oil companies as these are issued for medium to long term, and are only partly tradable the oil companies find it difficult to generate funds for working capital from these securities, and have increasingly been facing a short-term liquidity crunch the net profits of these companies have been fluctuating, and have even been negative in some quarters (three quarters of 2005/06) the profitability of oil marketing over the years has declined substantially The burden on exploration and production (E&P) companies increased from `140 billion in 2005/06 to `320 billion in 2008/09 The OMCs in the face of rising international prices have been facing massive under recoveries

On the Consumers
the penetration of these fuels remains limited, and so does the efficiency of their use As per the NSSO data (63rd round), almost 85% of rural households continue to depend on traditional fuels such as firewood, chips, and dung cakes as a source of cooking fuel. The penetration of LPG was limited to 9.1% of rural households since these traditional fuels have to be collected, it imposes an added burden on the women and girls of the householdswith the latter often having to forego attending school In the urban areas, on the other hand, almost 62% of households have access to LPG, thus implying that a large chunk of the total subsidies is being wrongly targeted Subsidized kerosene is used by almost 40% of rural households for lighting purposes. However, kerosene is an inefficient fuel for lighting Also since it is easily available, it is increasingly being used for adulterating diesel. According to a study conducted by the National Council for Applied Economic Research (NCAER), almost 40% of the kerosene consumed is siphoned off, highlighting the severity of the issue (NCAER 2005)

Analysis
We will first calculate the cost of producing and marketing petrol and diesel in India We shall then calculate the implicit subsidy that the government provides these OMCs We will also see how the government realizes the major chunk of revenue from these figures We shall then deduce are results and findings, based on which the conclusion is derived

The Various Components that go into deriving these costs

Various Components used in calculation of cost of fuel Amount of Crude oil produced in India Amount of crude imported Value of Crude imported in India Total fuel supplied to refineries in India Total fuel (MS/HSD) produced in India Total Price incurred in producing and importing crude oil Various Components involved in determining the cost of producing and marketing a Fuel Include: Cost of Production of fuel Marketing Costs Marketing Margins Return on working Capital Stock loss DLAF (Domestic logistic adjustment factor) Interest on working capital Terminalling charges Sales Tax levied by the state government Excise duty levied by the Central Government on basic price Customs Duty Levied by central government Dealers commission on sale of fuel

Cost of production of Fuel

Cost of producing Crude in India =Production of Crude in India X Cost of producing 1MT of Crude

Total Cost Incurred = Cost of producing Crude In India + Cost incurred in importing Crude in India

Total Crude Supplied to Refineries = Production of Crude in India + Crude imported in India

Cost of Producing MS/HSD = Total MS/HSD produced X Total Cost incurred Total Crude Supplied to Refineries

Cost of Producing MS/HSD per litre= Cost of producing MS/HSD Total MS/HSD produced

We will start with the cost calculation of petrol and then will calculate the cost of diesel. Let us consider the case of petrol or MS( Motor Spirit): (All the data are from the financial year 2009-10 and all the figures are in INR) Amount of crude imported: 159.259 million MT (1) Cost incurred: 375378 Crores (2) Production of crude by India: 33.691 million MT (3) Total amount of crude supplied to the refinery (1+3): 192.95 million MT (4) Cost analysis of production of crude (offshore and onshore) (Prices in Rs/MT)
Basic price 25530 Royalty 2633 Cess 2500 Sales Tax 791

T3: Various price components of petrol or MS, 2009-10 Figures taken from table T6 Weighted Average Crude Oil prices

Total price of producing 1 MT of crude: Total price of producing crude in India (3x5): Total price incurred (2+6):

31454/MT 105971.67 crores 481349.67 crores

(5) (6)

Total MS produced: Total MS produced (in KL): Price of producing 1 KL of MS: Other costs involved in the sale of MS: Marketing Costs Marketing Margins Return on working Capital Stock loss DLAF (Domestic logistic adjustment factor) Interest on working capital Terminalling charges

22.537million MT 22537/0.750= 30.049333 million KL 56222.73928 /30049.333 = 18.71/Litre

These costs accumulate to around a total of: Total price of MS/litre without duties and taxes: Sales tax on MS(average of 4 Metros [25.25% of basic price]) : Customs Duty (7.5% of Basic Price+Rs. 7.35/Litre): Excise Duty: Dealers margin in Delhi for MS: Retail price at which MS is available:

Rs. 5/Litre Rs.23.71/Litre Rs. 4.72/Litre Rs.8.75/Litre Rs.13.35/litre Rs.1.125/Litre Rs. 51.662/Litre

We will start with the cost calculation of petrol and then will calculate the cost of diesel. Let us consider the case of petrol or MS( Motor Spirit): (All the data are from the financial year 2009-10 and all the figures are in INR) Amount of crude imported: 159.259 million MT (1) Cost incurred: 375378 Crores (2) Production of crude by India: 33.691 million MT (3) Total amount of crude supplied to the refinery (1+3): 192.95 million MT (4) Cost analysis of production of crude (offshore and onshore) (Prices in Rs/MT)
Basic price 25530 Royalty 2633 Cess 2500 Sales Tax 791

Total price of producing 1 MT of crude: Total price of producing crude in India (3x5): Total price incurred (2+6): Total HSD produced: Total HSD produced (in KL):

31454/MT 105971.67 crores 481349.67 crores 73.281 million MT

(5) (6) (7)

73281/0.830=88290.361 million KL

Price of producing 1 KL of HSD: Other costs involved in the sale of HSD: Marketing Costs Marketing Margins Return on working Capital Stock loss DLAF (Domestic logistic adjustment factor) Interest on working capital Terminalling charges

1828130.877 /88290.361 =20.705/Litre

These costs accumulate to around a total of: Total price of HSD/litre without duties and taxes: Sales Tax(average of the 4 metros [19.23% of basic price]): Customs Duty(2.5% of basic price + Rs. 3.6/litre): Excise Duty: Dealers margin in Delhi for HSD: Retail price at which HSD is available:

Rs. 6/Litre Rs. 26.705Litre Rs. 3.98/litre Rs. 4.12/Litre Rs. 4.22/Litre Rs. 0.673/Litre Rs.39.65/Litre

Results and Findings

Based on the calculations done, we find that the cost of production and marketing petrol is : Rs. 51.662/Litre Now the retail selling price in Delhi during that period was Rs. 47.93/litre The implicit subsidy, in the case of petrol is :
Implicit Subsidy on petrol= Cost of production and marketing petrol-Retail Selling Price of Petrol

Based on above, we get the implicit subsidy as Rs. 3.732/Litre Major chunk of the price of fuel comes from the sales tax and excise/custom duties levied by the state and central governments

 In that case the indirect revenue of the government (accounting for the implicit subsidy) is given by

Revenue earned by government= (Duties+Taxes levied on fuel)-implict subsidy on the fuel

Based on the above, we get the revenue earned by the government per litre of fuel as: Duties+Taxes levied on Petrol (Rs./Litre)= 26.82 Implicit Subsidy= Rs. 3.732/Litre Revenue Earned= Rs. 23.09/Litre Percentage of taxes and duties of the retail selling price of petrol : 54 %

 Similarly we derive the same calculations for diesel, to obtain the implicit subsidy on diesel and the revenue earned in case of diesel Cost of producing and marketing diesel : Rs.39.65/Litre Retail Selling price of Diesel: Rs. 34.45/Litre
Implicit Subsidy on diesel= Cost of production and marketing Diesel-Retail Selling Price of Diesel

Based on the above we get the implicit subsidy as : Rs 5.206/Litre

Revenue earned by government= (Duties+Taxes levied on fuel)-implict subsidy on the fuel

Based on the above we get the revenue as Rs. 7.11/Litre

The taxes and duties form 37% of the retail selling price of Diesel

Impact of Subsidies on Government and OMCs

The indirect subsidy on petroleum products has been given by the government, the amount of subsidy keeps changing. This subsidy cost is shared by OMCs and government both. The government pays for 52% of the share to OMCs in terms of oil bonds and the rest has to be paid by the OMCs, which passes its burden to the upstream oil companies Petrol: Total MS produced : 22.537 million MT Implicit Subsidy/litre = Rs. 3.73 Total cost incurred in subsidy = Rs. 3.73 * 22.537 million MT = Rs. 8406.4 crores Now, Governments share = Rs. 0.52 * 8406.4 = Rs. 4371 crores OMCs share = Rs. 0.48 * 8406.4 = Rs. 4035.72 crores Similarly for Diesel, Total HSD produced : 73.281 million MT Implicit Subsidy/Litre= Rs. 5.20 Total Cost incurred in subsidy= 5.20* 73.281 million MT= Rs. 38106.12 Crores Government Share= 0.52* 38106.12= Rs. 19815.18 Crores OMCs share= .48* 38106.12= Rs. 18290.93 Crores

Conclusion
We find that the current pricing scheme bears heavy impact on the fiscal burden of the government and on the oil marketing companies as they suffer huge under recoveries Indias fiscal deficit (across all levels of government and including off-budget components) had more-than-doubled in nominal terms from 5.7% of GDP in FY 2007-08 to 11.4% in FY 2008-09 during the volatile period. Total state and central government debt is estimated at 82% of GDP. The prices of petrol are now market determined, which was done owing to large under recoveries faced by the OMCs in the volatile period of 2007-2009 The tax regime in the case of pricing fuel needs to be rationalized as well. Governments realize large revenues on petrol and diesel, and let OMCs bear major chunk of the losses. Thus tax/duty structure needs to be rationalized. Like in the case of Goa, where the govt had cut down on state taxes, to bring down the price per litre by Rs. 10 Owing to the large disparity between the prices of petrol and diesel in the country, the number of diesel cars sold in India has increased over the past few years. Industry data shows that while sales of petrol cars and other vehicles dipped by 15% between April 2011 and February 2012, the demand for diesel vehicles went up by 35% during the same period. the growing preference for diesel cars is already showing its environment impact with nitrogen oxide levels - a major diesel pollutant. These diesel cars emit 7.5 times more toxic particulate matter than comparable petrol cars. This means, one diesel car is equal to adding 7.5 petrol cars to the car fleet in terms of PM emissions and three petrol cars in terms of NOx emissions

Way Forward
Reforming fuel pricing regimes
Between FY 2004-05 and FY 2008-09, the GoI pumped over USD 60 billion into OMCs to absorb product under-recoveries and to ensure OMCs were capable of continued rapid investment in capacity. massive expenditure by the GoI to fund the system of unofficial product subsidies is entirely unsustainable. The best approach to petroleum pricing is to implement a fully liberalized regime, accompanied by appropriate regulation to ensure competition As an interim measure, however, governments can adopt automatic pricing mechanisms with smoothing mechanisms incorporated In the case of diesel, The burden of diesel price increase on agriculture depends on where it is used. In 2008-09, 12 % of total diesel went to agriculture (i.e., to tractors, thrashers, tillers, harvesters, pumpsets etc.). The cost of diesel in agriculture would be accounted for by the Government while fixing the Minimum Support Price (MSP) for major crops. Therefore, any increase in the cost of diesel will be reflected in the price and will not adversely affect farmers Higher diesel price will induce them to use less diesel which may reduce over-use of ground water prevalent in many parts of the country. Of course, higher diesel price resulting in higher MSP will increase subsidy for PDS, but it would be much less than the reduction in under-recovery on diesel.

In the case of increasing diesel car sales and its impact on the pollution level, below are listed some of the measures that the government can go for:
Discourage big cars and SUVs by linking taxation to the actual fuel consumption of the vehicles. More fuel a vehicle consumes the more tax should it pay. It is more scientific and effective to link the tax policy to actual fuel consumption.

Remove price incentive for diesel cars. Either equalise fuel taxes and prices or impose effectively high additional taxes on diesel cars to neutralize the current fuel price advantage that the cars enjoy. Kirit Parikh Committee has already recommended additional taxes on diesel cars to neutralize the benefit of fuel price difference
Introduce clean diesel technology and fuel on a nation-wide basis: India needs to set the timeline for the uniform introduction of clean diesel with sulphur content less than 10 ppm and mandate use of advanced particulate traps to near eliminate toxic particulates Need post 2010-emissions standards roadmap to reduce the pollution impact of motorization: At this moment there is no roadmap for uniform introduction of Euro IV and Euro V emissions standards across the country. The stepped approach of introducing tighter standards only in 13 cities benefits less than the quarter of urban population whereas the CPCB data shows that pollution levels are high across many small and big cities. Fuel economy standards must not worsen the trade-off between fuel efficiency of diesel cars and their toxic emissions. Fuel economy standards currently in the making must have built-in safeguards against dieselization of car fleet.